How to Use Morningstar's Retirement Portfolios

Jason Stipp: I'm Jason Stipp for Morningstar. Christine Benz, our director of personal finance, has created a series of retirement saver and in-retirement bucket portfolios for investors. They're quite popular on Morningstar.com. But how should you apply these portfolios to your own? Here to offer some tips is Christine Benz.

Christine, thanks for joining me.

Christine Benz: Jason, great to be here.

Stipp: First, how many of these portfolios do you have and how did you decide how they would be allocated?

Benz: So, the first set of portfolios we created were the six retirement bucket portfolios geared toward people already retired, and we created three traditional mutual fund portfolios from conservative to more aggressive as well as three exchange-traded fund portfolios also ranging from conservative to more aggressive. So, those were the six portfolios for retirees.

We saw that investors were interested in them. They liked that we brought together some of our favorite fund picks into well-diversified portfolios. So, we decided to roll out what we call Retirement Saver portfolios. These are geared toward people who are still working, still in accumulation mode. Here again, we have three traditional mutual fund portfolios, ranging from very aggressive (geared toward people in their 20s and 30s) to much more conservative portfolios (geared toward people who are getting close to retirement). So, here again, we have the traditional, active mutual fund portfolios as well as portfolios consisting strictly of exchange-traded funds.

Stipp: So, a set for folks in retirement and a set for folks who are saving for retirement. And you have some overarching principles to these portfolios that apply to both sets. Can you talk about some of those?

Benz: The portfolios are all geared toward retirement, so they are not geared toward helping investors save for any shorter-term goals that they might have. They are all geared toward retirement. We focused on low costs within each of the portfolios, so even within the portfolios consisting of active funds, we focused on very low costs because our data here at Morningstar show that that's a great way to stack the deck in your favor--in favor of long-term success. We tried to be minimalist when putting together the portfolios. So, we tried not to have too many moving parts. The portfolios max out at 10 or 11 holdings. Some of the portfolios have fewer. So, we tried to illustrate how investors can get by with fewer funds that require less oversight on an ongoing basis.

We are also going to be using a strategic approach to asset allocation. So, we are not going to try to time the market or get too active in terms of our asset allocation. We will periodically rebalance the portfolios to show how rebalancing works. We will also use the portfolios that are geared toward retirees to demonstrate how they can deliver cash flow during retirement, but we are definitely not going to be using a tactical approach to asset allocation. We are not going to say, "OK, the market in 2015 is seeming volatile--we are going to downplay stocks." That's not a skill set that we believe we have here at Morningstar. So, we are going to focus on a long-term, strategic buy-and-hold approach to asset allocation.

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Stipp: And for folks in those bucket retirement portfolios, you are taking a total-return approach versus an income-only approach. You're sort of blending the two. That might be a little different than how folks have traditionally thought about funding retirement.

Benz: Right. So, people think about retirement income and they think that that means that they need to focus on securities that are kicking off current income. The way we've thought about the retirement bucket portfolios is that we are using that total-return strategy; a retiree can use the income from dividend-paying stocks and bonds to perhaps deliver part of their needed cash flow, but one thing we've seen is that yields have gone down and down and down, and so an investor who was focusing strictly on income would be having to venture into ever riskier securities. To keep from having to do that, we've generally focused on high-quality equities, high-quality bonds, and then looked to rebalancing proceeds to deliver any additional income that we might need.

In lean years when the market hasn't been particularly strong and we haven't had any rebalancing proceeds, what we've done is that we have delved into the cash component of the portfolio to deliver any additional income that we need. Then, we've periodically tried to replenish that cash piece as it's become depleted.

Stipp: Something interesting that strikes me as I look at both sets of portfolios is the amount of equities. Even in some of the retirement bucket portfolios, there is ample equity exposure there. Why is that?

Benz: Well, the key reason is that when people think about their retirements, they might have time horizons of 20 or 25 years or even longer. Given where yields are currently, most retirees can't afford to make do with a very bond-heavy portfolio. They absolutely need the long-term return potential that comes along with equity exposure. So, while the saver portfolios geared toward people in their 20s and 30s have almost all equity exposure, even the portfolios that we've geared toward retirees--even conservative retirees--have at least 30% (in some cases more) equity exposure.

Stipp: So, let's talk about how we might use these portfolios, and we can start with the accumulation portfolios for folks who are still saving for retirement. What are some ways they can look at those model portfolios and apply the lessons to their own?

Benz: I think there are a few key ways they can use the portfolios. One of the main ways would be simply to guide their own asset allocations. A lot of investors have questions about what their asset allocations should look like--and of course, it's a very individualized answer. But the hope is that the portfolios' allocations can help give investors some coaching, and then they can customize their own asset allocations based on whatever they have going on. But certainly, helping them set some benchmarks for asset allocation is a goal.

Showing investors what specific funds one might use to populate a portfolio is another goal. So, we have drawn all of the exchange-traded funds and active mutual funds from our analysts' favorite picks. They are typically all highly rated investments we've used to populate these portfolios. So, certainly, finding the right holdings is another goal, another way that investors might use these model portfolios.

We also wanted to showcase, as I mentioned, the virtue of having a streamlined portfolio. Oftentimes, investors have more moving parts than they actually need in their portfolios. So, we were trying to say, "Here's what you can get away with and have a very well-diversified asset mix at the same time."

Stipp: You could also look at this as maybe a separate benchmark portfolio for performance purposes as well--how did this model portfolio perform versus the portfolio that you have?

Benz: I think that's a perfectly reasonable way to use the portfolios. We haven't tried to oversell the portfolios and say, "Well, they will beat everything else around." But we do expect them to perform reasonably well relative to, say, a benchmark that mirrors their asset allocation. So, I think investors could reasonably use the portfolio that roughly matches their own asset allocations to benchmark their own performance.

Stipp: Now, let's talk about the retirement bucket portfolios and how retirees may use those compared with their own portfolios.

Benz: One thing we will be doing on an annual basis is taking a look at how these portfolios would work in terms of delivering cash flow. So, we will be providing models. We've actually been doing this for a few years now where we've been including spreadsheets that walk investors through the logistics of where we're going for cash flow from the retirement portfolios.

Investors shouldn't look to us to make a lot of moves in these portfolios, but we will periodically be showing what we are going to do to deliver our desired cash flow needs from this portfolio on a year-to-year basis. And I think that might be helpful because, frankly, investors need guidance there. They need guidance in understanding, "Well, if my income isn't coming strictly from income-producing securities, how am I going to get it out of the portfolio?" So, that's what we're trying to illustrate.

Stipp: And when we've gone back and looked at how you could do that over the last 10 to 15 years or so, we've shown that you can get the income you need by doing some of this rebalancing and taking income proceeds.

Benz: Yes, and it's worth noting that when we look back over the past 10 years, even though there have been bumps along the way, it generally has been a pretty good market environment. So, I don't want to pat ourselves on the back too much in terms of saying, "Oh, this portfolio has performed really well." But it has, in fact, delivered on our expectations for it in terms of delivering our desired withdrawal rates while also actually building principal pretty nicely during the time frame. And specifically, the portfolio we've tested has been the aggressive in-retirement portfolio.

Stipp: Let's talk about some of the ways you shouldn't use these model portfolios. They offer great benchmarks and guidelines in some ways, but there are also some things you probably should avoid if you have your own portfolio. What are some of the ways you should not use them?

Benz: One of the key [mistakes] would be to construe the model portfolios as a call to reinvent the wheel. If you have great underlying holdings already, you can probably use those holdings; but you might want to model some of the same characteristics in terms of asset allocation or in terms of portfolio maintenance. That would be one of the key ways that I would think about using this set of model portfolios.

Stipp: And there also may be some considerations that would affect your own asset allocation; [for instance,] you might have more equity or less equity depending on other things going on.

Benz: That's a terrific point. So, the portfolios are time-horizon-based, but there might be investors who, for whatever reason, just are outliers within a given time horizon. So, a great example would be that person who is building toward retirement and is going to be able to retire with a full pension; in that case, that person, generally speaking, would probably want to have a lot more equity exposure than the person who is going to be looking to the portfolio, plus perhaps Social Security, for all of their retirement income. So, certainly, look at your own set of circumstances when deciding whether any of these portfolios is a good fit for you.

Stipp: And one of the circumstances, lastly, might also be if you're very concerned about taxes or minimizing tax exposure. You might need to make some tweaks to how you are running these model portfolios.

Benz: That's another great point. So, we put together these portfolios without regard for tax efficiency. So, we are assuming that investors hold them in some sort of a tax-sheltered account. If you are holding a big share of your portfolio in a taxable account, you won't want to model these exposures there. We are holding categories like Treasury Inflation-Protected Securities, for example--a notably tax-unfriendly category. If you hold it, you definitely want to make sure to be holding it within the context of an IRA or some sort of company retirement plan.

Stipp: Christine, these models have been great for investors. Thanks so much for joining me with these tips today.

Benz: Thank you, Jason.

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