4 Ways to De-Risk a Portfolio in Retirement

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. Many retirees and those about to enter retirement are looking for ways to de-risk their portfolios but might be concerned about going into bonds or cash at very low yields. I'm here with Christine Benz, she is our director of personal finance, to look at some chicken ways of de-risking your portfolio.

Christine, thanks for joining me.

Christine Benz: Jeremy, great to be here.

Glaser: So, let's talk about maybe the first is the gold standard of how to de-risk, which is rebalancing, going into those stocks and bonds. Why do you think that this is still the best way to take risk out of your portfolio?

Benz: Well, first, I would say there is a lot of confusion about what rebalancing does and doesn't do for your portfolio. Some investors assume, well, if they are telling me to rebalance, it must enhance my returns in some way; not really. When we look at some of the academic research that's been done on the virtues of rebalancing, most of it points to rebalancing being a risk-reduction tool. So, the basic idea is that you are looking at your portfolio's asset class exposures and you are taking them back to your target allocation. And this has the virtue of helping you sell your most appreciated positions and to things that potentially are a little bit depressed and maybe do for a comeback.

So, academic literature points to rebalancing being valuable from the standpoint of risk reduction. One thing to think about is that portfolios that haven't been touched--and I know a lot of investors have been pretty reticent to touch their portfolios, to sort of pull back on stocks when stocks have performed so well for so long--but the untouched portfolio is probably listing pretty heavily toward stocks at this point. So, if you were 60-40 coming into this great rally that we've had in the equity markets--so you are 60% equity, 40% bond--today you'd be roughly 82-20 and you are eight years older. So, that might mean that you should in fact think about scaling back on stocks and putting some money into the safer stuff in your portfolio.

Glaser: But even with that big runup and concerns about valuations, we hear from retirees who say, yes, stocks are looking expensive but bonds look even worse. What would be a way to kind of do that rebalancing that maybe would be less painful?

Benz: Well, one thing to think about, and this is a form of rebalancing, but the idea would be, if you have to figure out where you are going to spend from your portfolio, so if you're in drawdown mode, one idea would be to think about spending from your most appreciated portions of your portfolio. That will probably be your equity holdings, but use those withdrawals from those holdings to help meet your required minimum distributions, to help meet your annual spending needs. This is a way that, I think, retirees can maybe psychologically cope with this idea of trimming back on the appreciated pieces of their portfolios.

Glaser: You say another option is to spend the dividends that you receive instead of reinvesting them?

Benz: Right. I think a lot of us, I know, me included, when I set up accounts I kind of reflexively check those boxes that say, yes, I want to reinvest my dividend and capital gains distributions. But actually, withdrawing those distributions can be a good way to kind of at least not add more to those positions that have appreciated. So, this is something to consider with your equity holdings if you are in drawdown mode. It gives you a little bit more control over your withdrawals and helps keep you from plowing more money into securities that have already enjoyed a nice runup.

Glaser: Another option could be to let someone else do it. What are some of the pros and cons of going for an allocation or all-in-one fund that hold both stocks and bonds and letting them manage that difference?

Benz: I've actually been critical of these all-in-one funds for retirees who are in drawdown mode. And the key point that I've made is that all else equal you'd rather have some control over where you go for your withdrawals. So, by having discrete stock and bond holdings--rather than having them all under the hood of a single vehicle--you are in a position to actually say, well, today I want to withdraw from my equity holdings, maybe in a few months I will prefer to withdraw from my bond holdings. You actually have more control. And I've run some back tests on this question about whether you're better off having discrete stock and bond holdings or using some sort of even a very good all-in-one fund, and I have found that there are some benefits to being able to do that very specific pruning from stocks or bonds at any given point in time.

That said, people really love their all-in-one funds. In fact, when I think about the holdings that our Morningstar.com readers have the most enthusiasm for, a lot of them are these all-in-one vehicles and one of the reasons that investors say they like them is, A) they have delivered good results over time, and B) investors find that these all-in-one funds, they do some of that rebalancing work for them and they give them a lot of peace of mind. There's certainly something to be said for that. In fact, when we look at our data on investor returns, which attempt to kind of measure the intersection between investor behavior and how the funds have performed, what we see is that these all-in-one funds oftentimes deliver a really good investor experience. So, investors buy into them, and then they stay the course and that's what we want to see. So, I think that these all-in-one funds can be really effective in terms of managing overall risk and kind of managing your emotions about your portfolio.

Glaser: What are some of your favorite funds there?

Benz: Well, I've got a short list. Vanguard Wellington and Wellesley Income would have to be close to the top. Fidelity Puritan is another fund that our analyst team likes quite a bit, and we like Fidelity's bond operation quite a bit. So, investors harness that with that particular fund. FPA Crescent is another fund with the discretion to invest in various portions of the market. It has performed very well historically and historically have been quite low risk relative to its competitors.

Another idea for investors who are in drawdown mode, so retirees who are actively taking from their portfolio, would be Vanguard Managed Payout Fund. When I think of a single fund that comes closest to encompassing this bucket strategy that I often talk about, I would say that that fund probably comes closest to delivering. Finally, I would mention T. Rowe Price Capital Appreciation. It's pretty equity heavy and it's closed to new investors, but it's another fund that has historically delivered equitylike returns with much less risk than an all-equity portfolio.

Glaser: And if you do want to stay in stocks, you think that it could be a good idea to look at higher-quality names. What do you mean by that?

Benz: Well, when we look back on various periods of equity market turbulence, you try to find, OK, what are some recurrent themes within the equity market, things that have consistently held up well in down markets. I think it does come back to quality. And I would use our wide-moat designation as an approximation of firm quality. So, I think, investors could safely, if they want to make sure to hold equities and I think investors of all ages do need equities, but if retirees want to make sure to hold equities, I think they do want to emphasize some of those high-quality wide-moat stocks, whether they are picking those individual stocks outright or using some type of a fund. And one of the neat things that you can do on the site is that you can actually look at mutual funds' holdings by how much they hold in various moat segments.

So, I took a quick look at some of the funds with the highest weightings in what we call wide-moat stocks, so these are the companies with sustainable competitive advantages. Vanguard Dividend Appreciation, which is a traditional index fund as well as an ETF, is near the top of the list. Jensen Quality Growth is another name that fits the bill. AMG Yacktman Fund is another name as well as Mairs & Power Growth. So, just a short list of funds that our analysts like a lot on their own merits because the strategies are sound, the costs are reasonable, but that also align with our equity philosophy in that they too emphasize wide-moat stocks.

Glaser: Christine, thanks for your thoughts on de-risking today.

Benz: Thank you, Jeremy.

Glaser: For Morningstar, I'm Jeremy Glaser. Thanks for watching.