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Our Favorite Funds for Retirement Portfolios

Christine Benz
Jeremy Glaser

Note: This article is part of Morningstar's September 2016 Retirement Matters Week special report.

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. It's Retirement Matters Week here on Morningstar.com and I'm here with Christine Benz, our director of personal finance, to look at some of her favorite funds for retirement portfolios.

Christine, thanks so much for joining me.

Christine Benz: Jeremy, great to be here.

Glaser: You've created a number of model portfolios that are around your bucket approach for retirement investing. Can you talk a little bit about what that approach is and any unifying themes between these portfolios?

Benz: The bucket approach is pretty straightforward. The basic idea is that you are segmenting your portfolio by anticipated spending horizons. So money that you expect to spend within the next couple of years, you need to keep really safe, so you've got that in cash instruments. Then you're stepping out on the risk spectrum as your time horizon extends. So, in my bucket portfolios I've thought of the money needed for years three through say 10 of retirement is going primarily into high-quality bonds. And then for the long-term portion of the portfolio the money that you will spend further out in retirement, say year 10 and beyond, I've got that primarily in equity funds.

So, I've created a lot of different flavors of these bucket portfolios over the past few years, some fund family specific ones as well as some that graze across fund families and I've looked for a few unifying themes when selecting specific holdings. First, I've largely stuck with mutual funds. I have not used individual stocks, although retirees could reasonably do so. I've stuck with funds because they give you a lot of diversification obviously in a single shot. And for older retirees, I always recommend that they start stepping away from strategies that require a lot of hands-on oversight and that's something that you get with funds.

I've also looked for very low costs when I've recommended specific funds for these bucket portfolios. Low costs, of course, are important no matter what your life stage is, but they are arguably particularly important for retirees because when you think about shifting more and more of your portfolio into conservative investments as is usually the case for retirees, that means that the rate of return, the absolute return that you can expect from that portfolio is going to go down. So you want to make sure that costs are shaving as little of that smaller return as can possibly be the case. I look for widely diversified offerings. So I tend to steer away from more focused investment types. I look for funds that give us a lot of diversification in a single shot. So I'm generally looking for simplicity, for diversification, and for low costs.

Glaser: Let's start with core U.S. stock funds. This is going to be a big part of many investors' portfolios. You think that you could really keep it very simple here.

Benz: Absolutely. So, one easy way to do it, and I know Taylor Larimore, who is one of the chief Bogleheads, would agree with me on this, is simply to use capitalization-weighted index funds as the core of your portfolio, certainly for your equity portfolio. The beauty of a simple, very plain-vanilla capitalization-weighted index fund is that its costs will be very, very low. So, across providers it's not difficult to find funds or ETFs with expense ratios of under 10 basis points today. You're getting a lot of diversification in a single shot. In fact, for your U.S. equity exposure, for example, you could safely just buy that U.S. total market index fund and call it a day. So those are the key virtues of that type of product.

Glaser: You mentioned these funds are available both as traditional mutual funds and also as ETFs. How would investors decide which one is right for them?

Benz: It really depends on the investor. One key thing to think about for both products is that they will tend to be pretty tax-efficient. ETFs do have a little more tax efficiency on their side. But both products whether you're looking at a traditional cap-weighted index fund or an ETF, should be pretty tax-efficient because they both have the virtue of very low turnover. Vanguard's traditional index mutual funds are actually probably going to be as tax-efficient as their ETFs due to the specific setup that they've got going on at Vanguard. So both will be pretty tax-efficient.

Another thing to keep in mind is whether the investor values that ability to trade intraday. I would argue that most long-term investors should not value that ability. But if for whatever reason the retiree does value that ability to get in there and make changes to their portfolio during the day as opposed to waiting until the end of the day when the prices of all the securities in the portfolio get totaled up, then that ETF would be the better choice.

Glaser: Looking past the Bar Cap Index funds, a lot of your portfolios also have a dividend growth fund in them. Why do you think this could be a good building block for retirees' portfolios?

Benz: The key reason I favor those dividend growth strategies is to give these retiree portfolios a little bit of a higher-quality tilt. So, in my initial bucket portfolios one fund that I featured was Vanguard Dividend Growth. It recently closed to new investors. I replaced it with Vanguard Dividend Appreciation. I do like that quality orientation, the fact that these companies in these dividend growth portfolios have the wherewithal to increase their dividends over time as an important show of financial strength, and it tends to bring their volatility down a little bit relative to the broad market, which is an attractive feature for retirees as well.

Vanguard Dividend Appreciation is the one that we've currently got in our core bucket portfolios but our team also likes T. Rowe Price Dividend Growth. That's an actively managed fund, has slightly higher fees, but we think it's a very good investment offering. We also like Schwab U.S. Dividend Equity ETF. Its yield is actually a little bit higher than some of the products that we've just talked about. It kind of rides the line between being a higher yielding stock fund and one that's focused on dividend growth. It's important to note though that many of these core dividend growth products, the Vanguard funds I just talked about, for example, Dividend Growth and Dividend Appreciation, their yields will not be high in absolute terms. In fact, they are not even higher than the broad market. So, investors who are looking for current income from their portfolios, probably won't find it with these funds.

Glaser: But a lot of retirees are looking for that income. What kind of funds would maybe be better suited to someone really looking to generate that income?

Benz: Yeah. Ben Johnson, who heads up our passive research coverage here, I think kind of helpfully splits the universe of dividend-focused funds and ETFs into two camps--one what he calls the growers which we just talked about, one which he calls the yielders. And on the short list of funds that our team likes are Vanguard Equity Income. That's an actively managed fund. Another fund that the team likes is Vanguard High Dividend Yield. That's an index fund that's available as either an ETF or as a traditional index fund. Both of them feature really nice low costs and that means that more of their yields flow through to shareholders.

Glaser: Looking abroad, is it important for retirees to have foreign stock exposure?

Benz: It is. So, in my bucket portfolios I have maintained ample exposure to foreign stocks in the bucket 3 and sort of the long-term component of the portfolios. I think it's important anytime you've got foreign stocks in the mix, whether you're retired or whether you're an accumulator, it's important to understand that unless it's a hedged product, and that's a pretty slim segment of the universe, you're going to have some currency-related volatility associated with that product. So it's important to have a nice long time horizon.

In terms of specific investments that I've tended to favor, here again, cap-weighted index funds are hard to ignore. They give you a lot of diversification at very low expenses. And I think investors assuming that their time horizons are reasonably long can also think about some actively managed funds. As it happens, some of our favorite actively managed foreign stock funds are pretty boldly positioned. So bear that in mind that you will see some volatility. You'll see the managers making some bold bets. But on the short list of funds that the team likes would be Harbor International, Dodge & Cox International, some of the American Funds pop up on that list of sort of high-conviction, large-cap core foreign stock funds.

Glaser: And then last but not least, how about the bond component of the portfolio? What are some of the products that people should consider?

Benz: One fund that I find really easy to recommend for that money that you're using to kind of just step out beyond the cash component of the portfolio is Fidelity Short Term Bond. The reason I like it is that it tends to play at things pretty safe on the credit quality front and on the interest rate front. Right now the translation of that strategy is that yields are pretty low relative to what you're able to earn on true cash investments. But over time I think when rates perhaps return to a more normal level, we will see its return advantage, its yield advantage broaden out relative to cash holdings. So that I think is a nice, easy, conservatively managed short-term option to recommend.

For core fixed-income exposure, here again I think an intermediate-term bond fund is an easy product to recommend. You can use a total bond market index. When we look at bond products that tend to have a really good inverse correlation with U.S. equity holdings, the total bond market index products show very, very well. One thing to keep in mind though is that we have been seeing the duration on the Barclays Aggregate Index extending a little bit over the past few years. That means that its interest-rate sensitivity has been popping up. So you may see some interest rate related volatility if we do see the Fed take additional action to increase rates such a product may feel that a little bit more than some of the actively managed funds that emphasize corporate bonds a little more. So, on the list of actively managed funds in that core intermediate-term bond fund realm we would have Dodge & Cox Income; MetWest Total Return Bond would also be on the short list, Fidelity Total Bond, another nice product.

Glaser: What about muni bonds? I know a lot of retirees are interested in this.

Benz: Absolutely. So, for the taxable portion of a retiree's portfolio to the extent that the retiree wants to have fixed-income investments there, they would want to think about Fidelity's muni lineup. I know our analyst team thinks that they are really second-to-none in terms of analytics. Also costs are pretty low on those funds. Vanguard's muni lineup I think is decent. It's very low cost and pretty vanilla, and well-diversified. So, it's hard to go wrong with either firm on the muni front.

Glaser: And you have another pick in this space that you think should probably have an asterisk on it right now.

Benz: That's right. This is Tweedy, Browne Global Value. This is one that I own in Morningstar's 401(k) plan. It's a terrific fund with a great long-tenured manager team using a valuation-conscious, quality-conscious strategy. The thing that makes it a little different from the funds that I just talked about is that it is fully hedged to the U.S. dollar, meaning that it doesn't pick up the foreign currency fluctuations that I just talked about.

Now there is a lot to like about that from the standpoint of it being in a retiree portfolio that you don't get a lot of that foreign currency related noise. The caveat though is that the dollar has had a tremendous run relative to other foreign currencies recently. Its performance looks very, very strong because of that in large part. So, investors looking at it today I think need to bear in mind the possibility. And of course, I don't have a crystal ball that will tell me what will happen to the dollar relative to foreign currencies, but there is a possibility that we'll see some change about in terms of foreign currency performance that the dollar may not always lead other developed foreign currencies, other major foreign currencies, and that could be a headwind for it in the future.

Glaser: Christine, thanks for these ideas today.

Benz: Jeremy, great to be here.

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