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Investing Specialists

Wring More Income from a Portfolio

In search of extra income? Don't sacrifice stability.

My newsletter, Morningstar PracticalFinance, is designed to be your personal financial planner. In each monthly issue, I provide concrete advice for improving your portfolio and handling every aspect of your financial life. I also provide Portfolio Makeovers, in which I show you how to whip real-life portfolios into shape.

In a recent issue, I provided tips for maximizing your portfolio's income. The Portfolio Makeover from that issue is reprinted here.

Making adjustments to your portfolio to suit your life stage is one of the biggest challenges of managing your finances. Ideally, you'd make small tweaks to your portfolio every so often as you mature, but life gets in the way. I have often run into middle-aged individuals who have confided that they hold nothing in bonds, even though they recognize that it's probably time to give their equity-centric portfolios some ballast. They've been so busy working and saving that they haven't considered how to prepare their portfolios for retirement, when income and stability will be at least as important as capital appreciation.

In this month's Portfolio Makeover, let's look at how a hypothetical retired couple, both age 69, might adjust their portfolio to increase its levels of income and stability. While they've amassed a nice nest egg of $750,000, they'd like to ensure that they can make it last for the rest of their lives and leave something for their children and grandchildren. They estimate that monthly living expenses, including travel and leisure costs, total $5,500. Neither has a pension, but they're receiving Social Security benefits that total $2,700 a month. They're currently tapping their capital to pay their additional living expenses, but would like to see if they can improve the portfolio's income and total return potential.

 Retiree Portfolio: Before
Fidelity Contrafund (FCNTX)100,000
Vanguard Mid Cap Growth (VMGRX)100,000
Vanguard Equity-Income (VEIRX)50,000
T. Rowe Price Equity-Income (PRFDX)50,000
Artisan Small Cap Value (ARTVX)75,000
Julius Baer International Equity (BJBIX)50,000
Mutual European (TEMIX)50,000
Matthews China (MCHFX)25,000
PIMCO Total Return D (PTTDX)50,000
Cash200,000
Total750,000

Would You Like Some Growth with That Income?
Long gone are the days when retirement automatically translated into a portfolio focused on bonds and light on securities (i.e., stocks) with capital-appreciation potential. With average life expectancies in the U.S. rising by the year, running out of money is a real worry for many retirees. That, in turn, argues for retaining a fair amount of equity exposure in most retiree portfolios, because equity returns have historically been higher than bonds'. Of course, there are no one-size-fits-all asset allocations, but the typical retiree should have anywhere from 20% to 75% in stocks, depending on age, risk tolerance, and the size of the portfolio.

For retirees or anyone else managing their investments, a first step on the way to adjusting a portfolio is to arrive at an appropriate asset allocation. Morningstar.com's tool, available to Premium users of the site, is called  Asset Allocator.

 Retiree Portfolio: After
Fidelity Contrafund (FCNTX)75,000
Vanguard Equity-Income (VEIRX)150,000
Dodge & Cox International (DODFX)75,000
Kinder Morgan Energy (KMP)25,000
Buckeye Partners (BPL)25,000
Kraft Foods (KFT)25,000
BB&T Corp (BBT)25,000
Realty Income (O)25,000
Harbor Bond (HABDX)100,000
Vanguard Short-Term Inv-Grade (VFSTX)75,000
Vanguard Prime Money Market50,000
Immediate Annuity100,000
Total750,000

Retirees with relatively high risk tolerances might hold a sizable equity stake while at the same time adjusting the composition of their stock holdings to ensure an appropriate focus on income and stability. In the case of this couple's portfolio, that approach would argue for paring back some of the growth-stock exposure and also reducing its emphasis on small- and mid-cap stocks. Growth companies typically don't pay dividends, at least not substantial ones, preferring instead to reinvest in the own businesses. Their stocks also tend to be more volatile than those of dividend payers, which usually land in the blend or value columns of the Morningstar Style Box. And while many small- and mid-cap stocks do pay dividends, this couple's smaller-cap funds have very low yields. (Because their expense ratios are typically higher than large-cap funds', small-cap funds' expense ratios often gobble up most if not all of their dividend yields.) Additionally, reducing the growth and small- and mid-cap components of the portfolio helps reduce the volatility level of the overall portfolio.

I would also recommend eliminating some of the redundancies from the portfolio. For example, both  Vanguard Equity-Income (VEIRX) and  T. Rowe Price Equity Income (PRFDX) have a similar focus on dividend-paying stocks, but the former's lower costs ensure a higher payout. I would also simplify their foreign-stock holdings. Rather than holding three separate international funds, a single broadly diversified international fund with the ability to venture into emerging markets is sufficient here.

Using the proceeds from those sales, the couple could boost their portfolio's income stream by adding to their positions in individual dividend-paying securities. It's a mistake to chase the securities with the highest dividend yields without paying attention to the securities' risk and total-return potential. Instead, retirees like this couple will want to focus their attentions on building a diversified basket of stable, cash-flow-rich businesses. I've added small positions in some individual dividend-paying stock holdings that are rated highly by our equity analysts.  To further ramp up the portfolio's yield, I've also added two positions in master limited partnerships.

Making Room for Bonds
Although the couple can improve their portfolio's income and stability by adjusting their equity holdings, they also need to do some work on the bond side.  PIMCO Total Return (PTTDX) is a solid core holding with a flexible charter that gives management the latitude to invest in a variety of different bond types. But the D shares available to no-load fund investors are high. Instead, I'd recommend  Harbor Bond (HABDX), whose lower expense ratio ensures a higher payout. To further stabilize the portfolio, the couple could maintain a stake in a sturdy short-term bond fund. For their cash holdings, the couple should also park their cash in the lowest-cost money market fund they can find.

Finally, to ensure that at least part of their income stream is guaranteed for the rest of their lives, they could consider a low-cost fixed immediate annuity. By putting $100,000 into the annuity, they could receive a monthly payment of about $450. That might not sound like a lot, but that amount would be adjusted for inflation and cover both of them for their entire lives.

The end result is a portfolio that helps boost the couple's income stream and also offers more stability than their previous portfolio. At the same time, the portfolio's still sizable equity stake provides capital-appreciation potential and improves the chances that the portfolio will last throughout their retirement years and provide something for their children as well.

Note: If you're planning to undertake a similar portfolio overhaul, bear in mind any tax and transaction costs you'll incur to make the changes.  

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