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Where to Look for Retirement Income

Jason Stipp

Jason Stipp: I'm Jason Stipp with Morningstar. Although the stock market has seen a nice recovery in 2009, the yield environment for those investors seeking income has still proved to be quite challenging. These are especially investors who are in their retirement years who are depending on their portfolios for their day-to-day living expenses.

Here with me to talk about some of these challenges and some solutions for those seeking retirement income is Christine Benz. She's Morningstar's Director of Personal Finance, and the editor of Morningstar Practical Finance.

Thanks for joining me, Christine.

Christine Benz: Hi, Jason. Nice to be here.

Stipp: It seems like income investors are really in a pickle today. What are some of the factors that are causing the environment to be so hard for those income-seekers?

Benz: One of the key ones is the currently low interest rate environment. That's obviously a huge challenge. Cash yields now are close to zero, and you're not getting paid a lot more even to venture into an intermediate-term bond fund. So the interest rate environment is unfavorable.

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And also there have been pretty significant dividend cuts among companies that pay stock dividends. So those two factors have conspired to make it a really challenging environment for income-focused retirees, right now.

Stipp: So as more investors have been buying bonds this year, the yields on those bonds go down as the prices on those bonds go up, while the demand is there for them.

Benz: Exactly. And that's part of the conundrum here, is that coming into 2009, what we were certainly hearing from a lot of bond fund managers is that they were finding that they were really getting paid for the higher-yielding bonds that they were buying. So it was a good risk/reward trade-off.

But now as bonds have really rallied hard, yields have become more depressed, and you're not necessarily getting paid for taking the risk of higher-yielding bonds at this point.

Stipp: Turning to retirees and people who are looking at their portfolio to provide income to them for their daily needs, I think there's certainly this emphasis on wanting to just pull income out of the portfolio. But with yields so low, what are my options as a retiree, if I'm really hoping that my portfolio is going to be giving me that money I need day-to-day and month-to-month?

Benz: I would say this any market environment, but especially so right now, a total return approach beats a yield-focused approach in my view. So if you have to tap your principal to fund your daily living expenses, it's not the end of the world if you are able to preserve that principal better over time by not having to reach for some of these higher-yielding bonds that could see significant fluctuations in their principal value.

So I would emphasize that total return approach versus trying to fund daily living expense with yield alone.

Stipp: So it seems to me that investors really need to be aware of how much they're reaching for yield and the risks that overreaching might bring to bear on their portfolio.

Benz: That's right. In fact, if you use a total return approach and do have to tap your principal periodically, your principal value may in fact be higher over time than if you use a current income approach that actually entails greater risks.

Stipp: Now on the contrary side, a lot of investors may be reluctant to tap principal right now because they may see that their portfolio value is still depressed even after the nice rally that we've had. So if you are looking to beef up the income a little bit, what are some ways or some investment options I might consider to try and get a little more yield but maybe that's a safer yield? Where can I look if I am going to focus on income?

Benz: Certainly in the realm of bonds funds I would recommend investing with a bond fund manager who's really attuned to this issue. So you want a bond fund manager with a very flexible approach for your core bond holdings, and you also want someone who's using a value-oriented approach on the bond side. So you want a manager who's making sure that he or she is getting paid for any risks that they're taking on in the portfolio.

A couple of funds I would mention in this vein would be Dodge & Cox Income, Metropolitan West Total Return Bond, and then certainly at the more risky end of the spectrum I would look to something like Loomis Sayles Bond for a small portion of the portfolio.

Stipp: It sounds to me like maybe you wouldn't suggest indexing right now, given some of the risks that are out there, and some of the opportunities that an active manager could have in this space.

Christine: I love indexing in general. I think it's a great low-cost, very effective strategy. Right now though, certainly based on some intelligence that we're harnessing from fund managers, Treasuries still don't represent a great deal, and Treasuries take up a big share of most bond market indexes at this point.

So I actually think that probably if you're looking forward over the next five or 10 years, you'd probably be better off with an actively managed fund that would be downplaying some of the Treasuries right now.

Stipp: Thanks so much for you insights, Christine. It was a pleasure talking with you.

Christine: Thanks, Jason.

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