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Three Key Ingredients for Retiree Portfolios

Jason Stipp

Jason Stipp: I'm Jason Stipp for Morningstar.

Morningstar's Christine Benz, director of personal finance, last year put together three model portfolios for retirees: one for conservative, one for moderate and one for aggressive investors.

She is checking in on those portfolios again this year, and she is here today to tell us a little bit about some of the key concepts that she learned as she was pulling these together. Christine, thanks for joining me.

Christine Benz: Jason, nice to here.

Stipp: So among the key themes, among the key ingredients that might be a part of all of these portfolios, the first one is one that really, a lot of folks aren't talking about today, and that's inflation.

And a lot of people aren't talking about it because it's been very mild recently; a lot of folks maybe expect some deflation. But this is something that you must keep on your radar as a retiree.

Benz: Right, and it seems like even macro people who are thinking about long-term deflation/inflation trends are acknowledging that inflation should be on everyone's radar. And the key reason it's so important for retirees is that as they are steering an ever-larger share of their portfolios into safe, oftentimes fixed rate assets, inflation is going to gobble up a sizable share of those payments that you might receive from your portfolio.

So it's that much more important to add a measure of inflation protection to your portfolio.

Stipp: So, when you are thinking in percentage terms, obviously maybe that would grow as you get a little bit older, but what are some general targets for investors in retirement to think about the portion of their portfolio that should be in inflation protection?

Benz: Well, I look to Ibbotson Associates, which is a Morningstar company that focuses on asset allocation, for guidance on topics like this. And so, Ibbotson is typically recommending a stake in Treasury Inflation Protected Securities as a percentage of a fixed-income portfolio being in the range of 25% or 30% of that bond portfolio.

I think that's a good, useful rule of thumb and probably a higher TIPS sleeve than the typical investor makes room for. And also, the Ibbotson allocations call for 5% or 6% in commodities to add another measure of inflation protection, a different kind of measure of inflation protection, to that portfolio.

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Stipp: And inflation also is an important thing to keep in mind as you are thinking about other types of financial instruments that you might be using in retirement, including long-term care and also potentially for annuities.

How should I think about factoring in inflation as one of those important pieces for those products?

Benz: Well, if you are shopping for annuities, I would certainly enquire about whether you can buy inflation-protected annuities; there are some products in the market, and also for long-term care insurance. To me it's an absolute must that you do buy those additional riders that will give your benefits the ability to step up as health-care and long-term care costs step up.

Stipp: And certainly, we've seen a lot of inflation in that area more so than in some other areas.

Another important ingredient for retiree investors to think about, and maybe one that they don't always think about, is the long-term needs of their portfolio, because retirement is just a few year prospect, obviously. Knock on wood: It's a 20-year or maybe even a 30-year prospect. How should I think about that long time horizon?

Benz: That's the good news. We're all living longer, but that does mean that your portfolio really needs to last. And certainly, that is in part a function of the current low interest rate environment where you just can't get that longevity potential by sticking strictly with fixed rate assets right now. You need the growth potential that only stocks can afford.

And of course, if you look at stocks over the past decade it's not a particularly compelling proposition, but I do think that even retirees need stocks, and they might need a significant measure of stocks.

And they don't just need blue chip stocks, although I think that's an excellent starting point and an excellent anchor; I think they also want to think about a dose of international and maybe even a dose of small caps.

Stipp: So, obviously, very important to have a portion of your portfolios that's set up for that longer-term growth potential, but what about that part of the portfolio that I need right now, that part that I'm going to be drawing down from in the immediate future?

Benz: So, I think that's where the concept of creating that cash position to meet short-term needs is absolutely essential, Jason. So my portfolios don't include a dedicated cash component because it is individualized and that's going to vary as a percentage of your portfolio depending on who you are, and what you have, and what you're doing.

So, I did not include cash, a dedicated cash allocation in the portfolios. But it is very important to think about your near-term living expenses, and typically I tell retirees to keep anywhere from two to five years worth of living expenses in true cash, given how low cash yields are, you probably want to keep it on the low end of that range, and maybe invest the additional assets in say, a high-quality short-term bond fund or maybe even intermediate-term bond fund.

Stipp: Certainly, a lot of ingredients would go into your retirement portfolio, but three key ones; adjusting for inflation, making sure that you have some long-term growth potential in there, and making sure that you have that immediate liquidity--sounds like three primary ingredients for success.

Thanks for joining me, Christine.

Benz: Thank you, Jason.

Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.