For Retirement Cash Flow, All-in-One Investments May Not Fit the Bill

Note: This article is part of Morningstar's January 2014 401(k) Week special report. An earlier version of this article appeared March 10, 2011.

Life is complicated. So when it comes to matters of money and investing, "keep it simple" is my mantra. If an investment innovation helps cut the clutter in your life and allows you to get on with other things, I'm usually all for it.

For that reason, I've long been a big believer in all-in-one investments--whether they be traditional balanced funds or target-date offerings. Not all of these funds are worthwhile, of course, but the good ones buy a lot of diversification in a single shot, reducing the amount of day-to-day oversight one needs to devote to a portfolio.

That streamlining benefit from all-in-one funds is particularly appealing for people closing in on retirement or already retired. Not only are they apt to have better things to do with their time than manage their portfolios, but it's also wise to set up a portfolio that could run itself for a time in case the person should become disabled or pass away.

From the standpoint of helping an investor manage his or her own worst impulses, I also think there's something to be said for burying a lot of investments under the hood of a single vehicle. Some notable blowups notwithstanding, all-in-one stock/bond investments tend to deliver mild-mannered performance, neither shooting out the lights during stock-market rallies nor completely tanking during downturns. And if investors can't observe that their bond investments are flagging while their stocks are rocking the house, then they're less likely to performance-chase by ditching the former in favor of the latter. That hypothesis was tested during and following the recent financial crisis: Even as many other investors retreated to bonds, target-date investors stayed the course, benefiting from stocks' eventual recovery. 

What's Not to Like?
Those positives aside, all-in-one funds--such as target-date funds, so-called retirement-income vehicles, or traditional balanced-type vehicles--can be problematic for retirees who are drawing cash from their portfolios. That's because they don't allow the retiree to specify where the money is coming from when making withdrawals. When the retiree needs to sell shares to take a distribution, that money will come out of stocks and bonds in the same proportion the manager is holding in the all-in-one fund. If either stocks or bonds are going down at that time of the distribution, the retiree will be essentially locking in the losses. It's impossible to be strategic about what gets sold.

To use a simple example, say a retiree who was taking annual year-end distributions of $10,000 from his or her portfolio put $100,000 into  Dodge & Cox Balanced (DODBX) at the beginning of 2008. When the retiree needed to take the money out in December, his or her principal would have shrunk to just over $65,000, owing largely to the losses in the stock portion of the portfolio. The $10,000 distribution would gobble up 15% of the remaining principal value, leaving just more than half of the original principal in place to benefit from the fund's 28% gain in 2009. The stock piece of the portfolio was poised for a huge rebound in the years ahead, but both stocks and bonds get sold to meet the withdrawal. 

Are You Hands-On or Hands-Off?
Of course, some retirees might be OK with that arrangement. Assuming the all-in-one fund mirrors their target allocation and they'd like to take a systematic approach to liquidating their assets, selling shares of the all-in-one fund at regular intervals may be a reasonable hands-off way to go. (I outlined a version of this sort of liquidation strategy in this article.) While retirees who go this route would be selling some losing securities at a low ebb, as in my Dodge & Cox example above, liquidating an all-in-one fund on a preset schedule would also force selling of some securities when their prices were relatively lofty. Retirees could further smooth out the effects of market returns on their withdrawals by taking distributions at more frequent intervals, such as monthly.

It's also worth noting that all-in-one funds often rebalance back to their target asset-allocation weightings, selling winners and topping up losers. That helps give the remaining assets in the fund greater rebound potential than if the manager simply let the losing asset class sink lower and lower without rebalancing.

But some retirees might want to be more tactical about where they take money from, knitting their liquidation efforts into their own portfolio-rebalancing process or using valuation-based analysis to help determine what to buy and sell. (Poster Darwinian espoused such a strategy in response to my article about how to liquidate long-term assets to raise living expenses.) In late 2008, for example, such a retiree might have wanted to sell bonds, which had performed relatively well during the bear market, while leaving the stock portion of the portfolio more or less intact or even adding to those holdings. In such an instance, an all-in-one fund simply wouldn't allow for that level of control.

Help on the Way?
Given the widespread adoption of target-date funds and the fact that large swaths of the population are hurtling toward retirement, I'd expect to see the financial-services industry rolling out more elegant all-in-one solutions to address the shortcomings of most existing all-in-one funds when it comes to retirement-income distribution. Because of the large dollar amounts involved, every asset manager under the sun seems to be working overtime to craft the optimal retirement-income solution.

In the meantime, retirees who would like more control over where their distributions are coming from are best off avoiding all-in-one funds and instead should use discrete stock/bond vehicles that allow them to exert a higher level of control.

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