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What Should Your Portfolio Look Like in Retirement?

Jason Stipp
Christine Benz

Note: This video is part of Morningstar's October 2014 5 Keys to Retirement Investing special report.

Jason Stipp: I'm Jason Stipp for Morningstar. After spending years accumulating assets for retirement, newly retired investors may wonder, "What is my asset allocation supposed to look like now?" Here to offer some tips is Morningstar's Christine Benz, our director of personal finance. Christine, thanks for joining me.

Christine Benz: Jason, it's great to be here.

Stipp: I think there is a natural inclination for retirees when they approach retirement or they reach retirement age to want to batten down the hatches and become very conservative in their portfolios. But you say there are lots of virtues to maintaining a diversified portfolio in retirement.

Benz: Absolutely. And one of the reasons that I would urge retirees to be diversified and, certainly, to think about having stocks in their portfolio is when you think about that very safe portfolio that consists mainly of cash and bonds, for example, you're looking at a pretty low return, looking at starting yields today. Cash, you're lucky to earn 1%; you're not going to earn 1% today; bonds, maybe yields on some sort of a high-quality bond portfolio would be in the neighborhood of 2% to 3%. You're not even preserving purchasing power with that sort of return potential. Once you've got inflation factored in, you may even be in the red over your holding period. So, you absolutely need that higher return potential that comes along with stocks even though it's also accompanied by more volatility.

Stipp: On the flip side, you talk about how yields are so low right now, and there have been concerns for many years about bonds. But investors in retirement still need bonds in their portfolio.

Benz: They do. A lot of investors hate bonds today. They are very worried about what rising rates could mean for their bond portfolios. But I think the thing that retirees need to focus on is the fact that bonds will be that stabilizer in an equity-market downturn. We haven't had one for so long that my sense is that maybe some folks have become a little bit complacent about equity-market risk; but the potential for equity-market shocks is very much there and, in fact, we've seen some volatility recently.

So, you're looking for your bond piece of your portfolio maybe not to be a return engine so much but to be that piece of your portfolio that holds its ground in an equity-market downturn. And it's also important to think about the composition of that bond portfolio. We've seen a lot of interest in some of the higher-yielding, more credit-sensitive bond types. High yield maybe has been seeing a little bit of withdrawals recently, but generally there has been strong interest there because the yields are better--bank-loan, emerging-markets bonds, some categories like that. The risk of not having just that high-quality, very vanilla U.S.-bond exposure is that you will not have that same shock absorber in an equity-market downturn.

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Stipp: So, you need the bonds for balance; you need the stocks for growth potential and to outpace inflation over time. But what balance? How do I find the sweet spot between stocks and bonds for my retirement portfolio?

Benz: It's a tricky matter. I looked at Morningstar's Lifetime Allocation Indexes for a little bit of guidance on this, and what you see there is a really broad gradation in terms of recommended equity allocations. So, for the 2015 Lifetime Allocation Index for aggressive investors, it has 60% of the portfolio in equities. The conservative version geared toward someone who is already retired, had less than 20%. So, that's a huge gamut. Everybody had stocks in their portfolios, but the range of equity allocations was enormous. So, when you look at off-the-shelf sorts of allocation indexes or products, you're apt to see a pretty broad gradation.

Stipp: A lot of fund companies also provide a retirement-income fund--so, it's meant for retirees. What do the allocations in those funds suggest about what an asset mix might look like in retirement?

Benz: We've got a relatively new category called retirement income. There are a lot of different strategies being pursued within the category. It's a pretty big tent at this point. I would expect to see strategies continue to evolve in this group. But right now, the average equity allocation is about a third of assets. But these are one-size-fits-all portfolios. They are certainly not customized based on what the retiree or pre-retiree might have going on in his or her life.

Stipp: So, we have a range of options among the professionally managed funds. You say maybe a better way to get a handle on what your allocation should look like is to take on an approach that allows your cash flow needs to help dictate what your mix should be.

Benz: I think this is a sensible way to do it, and this is the strategy we've been pursuing when we've created these bucket portfolios. The basic idea is that we start [by asking,] "What are our income needs in year one of retirement? How much of those income needs will be supplied by certain sources of income--Social Security, pension, what have you." The amount we're left over with is the amount that we'll need that portfolio to supply in year one. I would take that number times two and park that in cash. That's what we often call bucket number one, and that's two years' worth of living expenses in true cash instruments.

And then the way that I've structured the portfolio is that I've been thinking about roughly eight years' worth of fixed-income exposure in addition to the cash exposure. And one way to think about how we arrived at that is when you think about equities over rolling time periods, historically, equities have had positive returns 95% of the time in rolling 10-year periods. So, that means that if your time horizon is at least 10 years, you've got a pretty good shot at having a positive number. If it's shorter than that, the odds are greater that you might have a loss in a 10-year period. So, to me, I think that makes it reasonable to think about maybe having 10 years' worth of the portfolio in nonstocks and the rest of the portfolio in equities.

Stipp: And so, for that longer piece, then, you would go into equities for the years after 10 and, as you say, over those longer time periods, especially over 10 years, you are not likely to see large losses in that part of the portfolio.

Benz: Exactly. And so, if the person has, say, a 30-year or 40-year time horizon in retirement, that means that maybe a third or a fourth of the portfolio would be in cash and bonds, but maybe the rest would be in equities. And of course, as the time horizon compresses, that will mean a higher and higher allocation to cash and bonds as the years go by.

Stipp: Christine, some very sensible advice for helping retirees triangulate an asset allocation. Thanks for joining me today.

Benz: Thank you, Jason.

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