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By Jason Stipp| 9-22-2011 2:30 PM

Weathering Volatile Markets in Retirement

With the right allocation plan, retired investors can avoid making big--and potentially costly--portfolio shifts during turbulent times.

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Jason Stipp: I'm Jason Stipp for Morningstar.

Volatility can make us all uneasy, but it's of particular concern to retirees, who are depending on their portfolios to fund those living expenses.

Here with me to offer some tips on how retirees can concur that volatility is Morningstar's Christine Benz, director of personal finance.

Thanks for joining me, Christine.

Christine Benz: Jason, great to be here.

Stipp: So we have seen a lot of volatility in the markets over the last few weeks for various reasons. I know especially retirees are apt to be checking in on their portfolios because they are depending on those investments. What are some tips for how you can get the right mind set to weather this volatility? I think your first one has to do with how the portfolio is constructed.

Benz: It does, and it gets back to that central point about asset allocation and the importance of giving due attention to asset allocation--so making sure that you have saved stuff in your portfolio, intermediate-term securities in your portfolio maybe bonds or hybrid mutual funds, and then a long-term piece.

And if you have adequate cash reserves set aside in that "safe" component, so this is maybe CDs, money market funds, possibly a very high-quality short-term bond. If you have that liquidity set aside to fund the next one or two years, ideally, in living expenses, you can really let those other parts fluctuate a little bit, particularly that long-term part that is doing the most fluctuation, you can actually live with that as long as that you know you have your near-term cash needs covered.

Stipp: So I know a lot of investors are apt to want to become more conservative when the market is very uncertain and when the economic environment is very uncertain.

What's wrong with really pulling a lot of that portfolio and making sure that it's stable and not going to lose value?

Benz: Well, a couple of things. First of all, if you do that, then you are sort of left with this nagging sense of, "how do I get back in?" "When do I know whether it's the right time to get back in?" I am guessing that people who got out or reduced their equity exposure during late summer when things were really bad have been probably looking over the past weeks and saying, "Now is this the time?" "Did I miss it?" So you are left with those nagging concerns. That's reason number one.

Then long term, if you sit tight with a very conservative portfolio, the big risk is that inflation is going to gobble up the earnings power of your savings, and so to me there is a huge opportunity cost, particularly given how low yields are on the safe stuff right now. The opportunity cost of staying too conservative is very great for retirees, particularly when you consider how long people are living. So, many people can expect to live until 85-90 or even beyond. That means that your portfolio has to last that many years. You have to have an awful lot of wealth to be able to make due on that very low yield that you are getting from safe stuff right now.

Stipp: So it seems to me you are saying resist the urge to make huge overhauls if you've already set a logical asset allocation in place.

Another reason I think to resist the urge to do that is some of these investments that you might make could be difficult to unwind should the market improve or the situation change?

Benz: Well, that's another thing to watch out for. So, for example, an immediate annuity might look really attractive just for that constant stream of steady income that you get from it, but at market inflection points like the current one, I think you want to be very careful about locking yourself into anything that could be difficult or costly to undue at a later date. So my advice in most matters is to kind of be a chicken about it, not make giant decisions, particularly during volatile times.

Stipp: So you mentioned earlier that it's important that you have a longer-term bucket or portion of your portfolio for those years in retirement that are 85, 86, 87 and beyond. How should you think about structuring that part of the portfolio, because that is going to be more susceptible to some of these swings that we're seeing. Those stocks are the ones that were up and down 3% and 4% in August. How can I try to control that within that longer term piece?

Benz: Well, I think diversification is key, obviously. For retirees, I usually save even for the stock component, the long-term component of your portfolio, you probably do want a higher share of defensive stocks than does someone who is younger and earlier in their career.

So our wide-moat companies, what our stock analysts call wide-moat companies, have historically been more stable in periods of market volatility than narrow- and no-moat companies.

So I always say for retirees building portfolios, look for a big share of those companies. So one fund that our analysts like a lot is Vanguard Dividend Growth, the actively managed fund. It has a big share of wide-moat companies. Jensen Portfolio is another fund that really exhibits that steady-growth characteristic that we like to see.

But I don't think you want to short shrift your portfolio entirely of more aggressive investments, so I actually think in a very volatile period, you probably want to make sure that you have a bargain-hunter working for you or be a bargain-hunter yourself, so you can actually scoop up some beaten-down names when they are in a trough, as they may be right now.

Stipp: So, that's an important point – because you have that longer-term piece of the portfolio, these can still be good opportunities to be opportunistic, and you shouldn't necessarily hide from that because you can make, sometimes, your most money in these downturns.

Benz: Exactly, and you could also look at moving things around a little bit to the extent that you have stock holdings stashed in a taxable account. One worthwhile thing to do at a time like this is just to see if you can do any tax-loss selling, especially as we close in on year-end to see if anything that you purchased is selling below the price where you bought it. It might be a good idea to get out of that, trade into something else and harvest that tax loss.

Stipp: So, again, just want to reiterate, it's important, we are talking about this in the context that you have the bucket with your liquid investments that's going to last two years.

And when you are thinking about longer-term bucket, there are some opportunities to be opportunistic there.

I wanted to ask you Christine about [what has been] traditionally thought of as the safest investments, Treasuries. What do you think about the allocation to Treasuries? There has been a lot of people who thought that Treasuries were not a good place to put money, yet we have also seen Treasuries do quite well over the last few weeks.

Benz: That's right, and I think that some bond market gurus thought that you really want to be short-shrifting Treasuries, but I think we have now been through a few market shocks where we have seen that in a true flight to quality, true flight to safety, Treasuries will tend to hold up best. So, I do think that rather than running without any Treasury exposure, you probably do want to have some component of your portfolio that's still in government bonds, Treasuries and TIPS included. But I do think that the market gurus are correct in that you are really not getting paid much at all to hold Treasuries, so there is a big opportunity cost. You want to be diversified within the bond component of your portfolio.

Stipp: So, diversification on that more conservative side and also on the more aggressive side are very important.

Christine, a portfolio-planning question: What about your withdrawal rate? Should you adjust that during these times of uncertainty? Does it makes sense to try to pull that in if you can?

Benz: Well, possibly, but part of the beauty of this whole bucket system and looking at your liquidity needs and making sure that you have adequate cash reserves is that it should keep you from having to make those lifestyle adjustments.

If you figured out that your withdrawal rate is sustainable, you shouldn't have to recalibrate your lifestyle, but if we are in a period of a sustained downturn like we were in 2007 through early 2009, what a retiree might consider--and this is based on some interesting T. Rowe Price research during that period--he or she might consider actually foregoing that inflation adjustment that is typically part of taking withdrawals in retirement. You might not do the inflation adjustment piece, just stick with your nominal withdrawal rate for that period of time when the market is undergoing big losses, and then possibly step up inflation at a later date. But that's one idea where you don't have to drastically scale back withdrawals, but maybe just forgo that inflation-adjustment piece.

Stipp: At least we saw that inflation was very tame during that last downturn. I don't think that's always the case historically that you will see very tame inflation when the market is suffering, but at least it was something that we saw recently.

Benz: Exactly, Exactly. So, the T. Rowe Price study I think does maybe anchor on that idea as well.

Stipp: So, Christine, one thing that I want to talk to you about is, it sounds like a lot of what you are saying is that you might not have to make a whole lot of changes, but at the same time it is kind of hard for me to just sit in a moment like this and just watch from the sidelines.

Is there anything that I can do? We mentioned opportunistic buying as one. But anything else where I can feel like I am taking advantage of the situation and making sure that I am staying on track, without screwing anything up?

Benz: I think the opportunistic buying is one. Also, scouting around for tax-loss candidates is another. Right now shopping around to make sure that you are getting the best yields that you can on these cash accounts--if they are two years' worth of living expenses, that could be a nice chunk of change. Make sure that you are wringing as much out of that component of your portfolio as you can. And finally making sure that your investment costs are as low as they can possibly be. I think that's a very empowering thing for investors to take a look at, make sure that they are considering all-in costs of investing, and making sure that they are putting downward pressure on those.

Stipp: Christine, some great practical tips for retirees in a time of volatility. Thanks for joining me.

Benz: Thank you, Jason.

Stipp: For Morningstar, I am Jason Stipp. Thanks for watching.

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