Benz: 5 Fund Picks for Conservative Retirees

Note: This video is being re-featured as part of Morningstar's November 2014 Risk Management Week special report. This video originally appeared in August 2014.

Jason Stipp: I'm Jason Stipp for Morningstar. Investors approaching or in retirement will naturally want to play it a little bit safer with their portfolios, especially after the volatility of the last 10 to 15 years in the market.

Here to offer some of her favorite ideas for more conservative retirees is Christine Benz, our director of personal finance. Christine, thanks for joining me.

Christine Benz: Jason, great to be here.

Stipp: So, investors will want to play it safer as they get closer to retirement, but maybe not too safe. There can be some risks to being too conservative.

Benz: Right. The best way to make your portfolio more conservative is to make an adjustment to your asset allocation. But you don't want to go overboard with that because when you look at what cash and high-quality bonds are yielding today, together it's hard to see how those two can out-earn the inflation rate. If you have a long time horizon for your retirement--so you expect to be retired for 15 or 20 years or even more--you can't afford to have so much staked in very safe securities. You need to nudge out on the risk spectrum, and you need to hold stocks in that portfolio.

Stipp: So, because of the need for short-term cash for living expenses but also longer-term investments because retirement could be a longer-term prospect, you often use or recommend what's called a bucket approach and these picks will align with that approach. Before we get to them, though, can you explain just the basics of the bucket approach?

Benz: I will. Harold Evensky is the originator of the bucket concept and, basically, it's a way to segment your portfolio for retirement based on your anticipated income needs. So, Evensky's key idea is that you have near-term cash needs set aside to cover those living expenses as they occur, which can allow you to withstand a little bit of volatility in the longer-term parts of your portfolio.

So, it's basically just a segmentation by time horizon. And I think it helps retirees see that "Well, if I'm not expecting to need the riskier parts of my portfolio until many years from now, I can afford to take some volatility there and earn some higher returns in the process."

Stipp: Playing it safe and using a bucket approach, obviously, doesn't mean that you're not holding stocks. You will be holding stocks--

Benz: Yes.

Stipp: --but you can tilt each of those buckets to be a little bit more conservative if you so desire. Let's start with bucket one; those would be the assets for your near-term needs. How would you play it safer there?

Benz: Here, I think that you don't want to take any risk at all. So, this is money that you'll use over the next one to two years of your retirement. When you look at the yields on shorter-term bonds right now--some sort of a shorter-term bond fund--they are hardly higher than what you can earn on just holding your money in true-cash instruments.

So, in a bank savings account, checking and savings accounts, money market account, money market mutual fund, you really are not getting paid to take on that little bit of interest-rate sensitivity. So, for conservative investors, I say for near-term expenses play it very safe; stick with true-cash instruments.

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Stipp: Bucket two is also generally going to be somewhat safe because it's for intermediate-term needs. But if you wanted to tilt that to be even more conservative, what might that look like and what kind of investments might you consider?

Benz: Here, when I'm thinking about this bucket two--this intermediate-term bucket--I'm typically thinking of a time horizon of maybe for years 3 through 7 to 10 of retirement. So, the goals are stability, preservation of purchasing power, some income, and perhaps a little bit of growth potential. When I think about the complexion of that portion of the portfolio, I think it needs to be anchored in some sort of a core-type bond vehicle.

There are a few that we like in this realm, but I think what you want is a sturdy intermediate-term bond fund, and I think you want one with a good deal of flexibility because we really don't know what the future holds for bonds. I don't think any of us could have predicted that we'd see bond yields actually go down so far in 2014. So, I think you want to be with a fund that's flexible, opportunistic.

Metropolitan West Total Return Bond, I think, is a good example of that. I don't want to oversell that it's a very conservative portfolio--it's not, typically. For example, the managers currently have a stake in non-agency mortgage-backed bonds; that's not a particularly conservative part of the bond market. But I think that the flexibility that this fund's managers have is a very attractive quality. It's a seasoned team here, reasonable expenses, and--the big selling point--a lot of latitude to range across different parts of the bond market.

Stipp: You also have a pick for this bucket that’s inflation protected, but it's a certain kind of TIPS [Treasury Inflation-Protected Securities] fund.

Benz: That’s right. You do want to make sure that you are preserving your purchasing power with this portion of the portfolio because your time horizon is a little bit longer. For that first bucket, [there is] probably not too much of a need to worry so much about inflation protection; with this part of the portfolio, I do think that you want to think about layering on a little bit of explicit inflation protection.

One fund that I have been talking about ever since it launched is Vanguard Short-Term Inflation-Protected Securities; it's a very vanilla sort of inflation-protected bond fund. The reason I like it as opposed to some of the longer-duration TIPS funds is that it doesn't have a lot of interest-rate-related sensitivity. So, Vanguard's core TIPS fund, Inflation-Protected Securities, currently has a duration of about eight years. This fund's duration is about 2.5 years or even less. So, you're going to have a lot less interest-rate-related noise. You'll also have a lower yield because the fund invests exclusively in short-term securities, but I think that that trade-off is a reasonable one.

Stipp: Your last pick for bucket number two is a hybrid fund that own stocks and bonds. Why do you like this one for a little bit more conservative investor?

Benz: This is a fund that I know our readers and viewers like a lot too, Vanguard Wellesley Income. The idea is that at least for the longer-term portion of this bucket two, you can take a little bit more risk and perhaps even have a little bit of equity exposure. This fund invests roughly 60% to 65% of its assets in bonds and it invests the remainder in dividend-paying stocks.

One thing we've been watching--and I know our analyst has been keeping an eye on this issue--is the fact that it is pegged to a certain index that keeps its duration within a certain band. He expects it to be somewhat interest-rate sensitive going forward. I think the stock piece of the portfolio, as well as if you have a bucket three with stock holdings, should help offset that interest-rate-related volatility.

Stipp: Let's move on to bucket three, the longer-term portion of your portfolio. To be clear, any bucket three with stocks is going to be more volatile than your other buckets, but there are ways you can tilt this bucket to be more conservative with more conservative managers. So, what are some of your ideas here?

Benz: One of the funds that I have put in the model bucket portfolios that we have for retirees is Vanguard Dividend Growth. I have used it as the core equity position. The reason I like it is that it's kind of just the high-quality slice of the domestic-equity market. Its manager focuses on companies with really strong franchises, and he looks to buy them when they're trading cheaply.

He generally steers clear of more cyclically oriented names. So, you are not going to find a lot of cyclical industrial stocks here. Even technology stocks tend to be not well-represented in this portfolio. But it does have a very experienced manager and management team. It's run by Wellington Management and Don Kilbride in particular. Very low costs are also an advantage for this particular portfolio.

It's a really easy fund to recommend, even though its recent results have not been great. As a defensive equity play, I think it's very, very solid.

Stipp: Your last pick, also for bucket three, has an international flavor.

Benz: That's right. This is one that I own. It is Tweedy, Browne Global Value. One reason I find it is so easy to recommend for retirees is that it does not have foreign-currency exposure. So, its managers hedge out all of that foreign-currency risk, and that's a wildcard that retirees, in my view, might not need. They don't need those foreign-currency fluctuations. This too is a very high-quality cut of the foreign-stock market. Its managers look for similar characteristics to what Vanguard Dividend Growth is looking for. So, they look for high-quality franchises, and they look for companies that they think are trading cheaply. In a lot of ways, it's kind of a Buffett approach on this particular fund.

Stipp: Christine, the bucket approach is a very sensible and accessible way to plan for retirement. And for investors who want to play it a little bit safer, [these are] some great picks as well. Thanks for joining me.

Benz: Thank you, Jason.

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