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Setting Your Fixed-Income Allocation in Retirement

VIDEO: Morningstar's Christine Benz explains why retiree portfolios may not be as bond-heavy as you think

Jason Stipp 15 December, 2011 | 2:17PM

Jason Stipp: I'm Jason Stipp for Morningstar. We got a lot of questions from readers during Morningstar's recent Retirement Portfolio Week, and a lot of them had to do with setting your fixed-income allocation in retirement, obviously a very important question for folks who are nearing those retirement years.

Here with me to offer some insights on that important question is Morningstar's Christine Benz, Director of Personal Finance.

Thanks for joining me, Christine.

Christine Benz: Jason, good to be here.

Stipp: A lot of people would traditionally think that as they approach retirement and get close to those years, their portfolios are going to be very, very heavily weighted toward fixed income. But the truth of the matter is that might not necessarily be the case.

Benz: Well, the prevailing wisdom really isn't that you would have most of your portfolio in fixed income by the time you reach retirement. Of course, it's very individual specific, but I often look at the research that Ibbotson Associates, our affiliated company, puts out about asset allocation.

So, when I look at Ibbotson's recommendations for someone who, say is 59, so closing in on retirement, and someone with an aggressive time horizon: Based on these indexes that Ibbotson puts together, that person would have something like 25% of their portfolio in fixed income.

Stipp: So, not even the majority of the portfolio in fixed income...

Benz: No, and of course that's a very aggressively positioned portfolio. But even for the person who's very conservative and maybe closing in on age 70, based on these indexes, the portfolio would still have a healthy weighting in stocks, something like 25%, and then just about 65% or so in fixed income. And again, that's for someone with a very conservative profile, low risk tolerance.

So, that does argue that even for people who are getting ready to retire, your portfolio may not be predominantly bonds.

Stipp: You mentioned that there are some other factors. This is obviously a very individualized decision to make about the asset allocation. One of the important things to consider is your income streams. How might that affect how much you should have in fixed income?

Benz: Well, it's really a big swing factor, because one of the reasons you're holding bonds is because you're readying portions of your portfolio to be tapped for income. The less you're going to be needing to raid that portfolio for income, the less that you'll need to hold in cash and bonds.

So, some of these big swing factors that would argue for lower weightings in bonds would be having already purchased some annuity to sending you a stream of income for the rest of your life, certainly having a pension and of course that's a dwindling group these days, that would also argue for a smaller weighting in fixed income. And finally anyone who has a part-time job in retirement or maybe even a full-time job in retirement. So, a person who has a lot of their living expenses covered by the money they're earning, that means that you have to have less sitting in cash and bonds because your near-term income needs are already covered, at least somewhat.

Stipp: Not having to rely on that portfolio for portions of the income can actually have pretty big effect, depending on what those income sources are.

Benz: You know Mark Balasa, who sat on our panel of retirement income specialists joked about how clients always say, "well, don't include the Social Security when you model out how much I'll need, or how much I'll be spending in retirement. Don't include it. I'm not sure it will be there when I need it."

So, he says, he'll run the calculations both ways and then show clients, and clients always say, "Eh, leave it in; I like it better assuming that Social Security will be there." So, certainly those certain sources of income can be very important.

Stipp: Key parts of the plan.

Benz: Yes.

Stipp: So, the questions today, though, about fixed income--are certainly setting that evergreen advice about where you would put or how much you would put in fixed income, some people are questioning that today, because the fixed-income environment is very cloudy. The yields are low right now, but there is the chance that rates are going to go up. People are concerned about their fixed-income holdings. They are wondering if they should scale it back because of that environment.

What do you think are some of the options that people have and how advisable is it to start tinkering with that traditional allocation that you have in fixed income?

Benz: Right. People are so concerned, Jason.

So the allocations that I was just mentioning, the work that Ibbotson does, it's all strategic, based on long-term projections about what various asset classes will return. Not thinking a lot about the current environment, but that's what investors are thinking about.

So, one strategy I am hearing a lot about from retirees or pre-retirees is, why don't I just take this fixed income rather than being a sitting duck here and letting interest rate hikes smash my fixed-income portfolio, why don't I move that into cash?

And I don't think that's a completely unreasonable strategy with part of the fixed-income portfolio, and you might also take a part of your fixed-income portfolio, and at the very least make sure that you are not exposed to long-term bonds, which will be the most interest rate sensitive.

But I think a key risk of going overboard with that all-cash strategy is that in terms of real yields--inflation-adjusted yields, you are not breaking even with cash as a long-term strategy. So, you need to be really careful. I wouldn't buy into that all-or-nothing scenario with cash versus bonds.

Stipp: So, Christine, another thing that we are hearing from retirees is that they are taking some of their fixed-income investments, and they are considering going into other types of income-producing securities, such as dividend paying stocks or MLPs. What's your take on that strategy?

Benz: Well, actually I think it can be a great strategy Jason, because it buys you some diversification. But again, as with the cash decision, I don't think you want to be all or nothing. And the key reason, you and I have discussed this on many occasions, is that the volatility profiles of even high-quality dividend-paying stocks versus bonds are quite different, and you're apt to see much greater gyrations in your portfolio's value with dividend-paying stocks versus bonds, even if we do see interest rates ratchet up over the next few years. Bonds will still probably have less volatility than you'd have with dividend-payers.

Stipp: So, important to think about the whole risk profile of the portfolio and how you'd be changing that if you did devote those fixed-income assets to other asset classes.

So, last question for you, a lot of folks in retirement are also invested in munis because of the tax advantage of municipals, but there are a lot questions about the municipals credit worthiness these days, and folks are wondering should I be in munis at all? What's your take on that?

Benz: Well, munis have really gotten crushed recently too. So, people have been pulling money out of municipals. I think that munis can certainly make sense, particularly for folks who are in the high tax brackets. The key message would be to stay diversified. My view is to go with a fund versus individual securities, because you're buying yourself diversification and also some professional management there.

There have been recently some stories about how transparency for investors just isn't very good when selecting municipals. You have to wonder how the pros are doing it. For individuals, it's hard.

But I think even if you've run the numbers and decided, well, I do need munis because I am in a high tax bracket, you still want to augment them with some taxable bonds, even for your taxable portfolio, and the key reason is diversification.

So, U.S., municipalities are all exposed to a similar set of factors; they may not all be in bad shape, but by owning other types of bonds, corporate bonds, even foreign bonds, you are getting some diversification. So, you don't want to be all in munis or all out. You want to mix it up a little bit.

Stipp: Christine, some great evergreen and timely tips for your asset allocation in retirement. Thanks for joining me.

Benz: Thank you, Jason.

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

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

About Author

Jason Stipp  is Editor of Morningstar.com, the sister site of Morningstar.co.uk.

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