Optimizing a Retirement Portfolio for Income

How can retirees build balanced portfolios that emphasize income production? Morningstar's director of personal finance, Christine Benz, discussed this topic with the head of retirement research for Morningstar Investment Management, David Blanchett, who has published a study on income-oriented portfolios.

Christine Benz: You co-authored a research paper about optimizing portfolios for income production. Often, when retirees are looking at optimizing their portfolios, they focus on total return, not just income return. What's the fundamental underpinning behind favoring a total-return strategy for generating retirement income?

David Blanchett: Total return is the combination of price return and income return. There are two pieces there. And when you think about designing portfolios, the focus really should be on total return. Because what do you earn every year as an investor? A total return. But for better or for worse, there are investors out there who like the idea of not touching the value of their portfolio and just living off the income. Those are the people who could benefit from an income-optimized portfolio.

Benz: When you're thinking about optimizing a portfolio with an emphasis on income, what types of investments move to the fore and get greater prominence in the portfolio versus a total-return-centric portfolio?

Blanchett: Obviously, with a portfolio focused upon total return, there are going to be two types of volatility: There is the price return and income return. With income return, you are really just focused on creating a portfolio that provides a consistent stream of income month over month, year over year. Along those lines, certain asset classes look a lot more attractive.

One example of an asset class that becomes more attractive in an income-focused portfolio is long-term government bonds--because long-term government bonds can be very risky. But as interest rates rise or fall, they provide consistent income year over year. Other asset classes like emerging-markets debt and preferred stock are examples of asset classes that look more attractive through an income lens versus the total-return lens.

Benz: In other words, these might be niche classes in the context of a total-return portfolio, but they would get greater prominence in an income-centric portfolio. How do you think about allocating across these various income-centric asset types?

Blanchett: What we found in the research was that an income-focused portfolio is going to be a little bit less diversified. When building an income-centric portfolio, you're really looking at what types of asset classes create income and which combination of those asset classes makes the portfolio the most consistent over time. Things like preferred stocks you probably rarely ever see in a total-return portfolio, but they are a lot more efficient in that income-focused portfolio.

Benz: In some respects, would you say that the income preference is a little bit irrational, in that you are just focusing on one piece of the puzzle when, in the end, doesn't it just matter how your portfolio grows over time?

Blanchett: It really does. In theory, it shouldn't matter whether your holdings generate the income or if you have to sell a part of your holdings to receive income. But let's be honest, people aren't always the most rational investors. Our new research acknowledges that there is a cohort out there that really does not want to touch the principal and would rather live off of that income on some regular basis.

Benz: If I'm approaching retirement, how do I decide which camp I fall into? Do I pursue a more traditional total-return structure or do I try to build a portfolio primarily for income?

Blanchett: I think that the vast majority of folks are going to be total-return investors, because at the end of the day, you need a portfolio to provide income for life. And most retirees can't afford to just live off of the income from their portfolio every year. So, I think you've got to ask yourself, as an investor, do I really just want to have a portfolio that creates a consistent income where I'm not worried about the total-return fluctuation, or am I more like everyone else? Do I really care if my portfolio goes down by 20% or 30%? If I am, then I should be investing for total return, not just income.

Click here to read the full report: Efficient Income Investing.

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