ETFs: A Total Return Approach to Retirement Income

VIDEO: Morningstar's Christine Benz outlines the mechanics and reasoning behind the total return approach to ETF portfolios

Jason Stipp 7 March, 2012 | 7:42PM
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This video was originally produced with US investors in mind. The principles remain for UK investors but we recommend checking the tax implications of investing in ETFs by reading our article Taxes and ETFs: A Guide for British Investors.

Jason Stipp: I'm Jason Stipp for Morningstar.

It's ETF Investing Week on As part of this week, Morningstar's Christine Benz revisited some ETF model portfolios for retirees.

Those portfolios follow a total return approach to generate that paycheque in retirement that retirees are searching for. She is here to explain a little about how that approach works.

Thanks for joining me, Christine.

Christine Benz: Jason, great to be here.

Stipp: So, normally you think, when you are in retirement, you need that portfolio to throw off some income for you. You need to basically be able to draw the money for living expenses out of it. You've chosen with these ETF portfolios to take a total return approach versus an entirely income-generating approach. Why is that?

Benz: Well the key reason, Jason, is that, right now given the current low-yield environment, it's awfully hard for people to leave on yield alone. So, you either have to have an awful lot of wealth, in which case you may be able to get buy on 2% or 3% yields, or you have to be venturing into some risky income-producing investments. Right now, I fear that some investors are doing just that; we're seeing very strong flows into some of these higher-yielding categories like bank loan funds, high-yield funds. My concern is that investors are possibly taking on more credit risk than they should be, and they may be in for an unwelcome surprise if we do see some correction in those markets.

Stipp: So, given today's environment, it's important to think outside the box. I think traditionally, retirees would like to think of their portfolio as this principal that they protect and then this income is thrown off that they use, and they don't have to touch that principal, but that just might not be viable in today's environment.

So, if you are going to look at a total return approach, so basically you're going to also depend on some capital appreciation to help that portfolio sustain itself, how does that work? How do you put that into action and translate that to ultimately some kind of an income stream?

Benz: Well, the starting point would be to gauge your income needs. So, look at how much you need your portfolio to generate, so income that isn't going to be provided by Social Security or a pension. What you need your portfolio to kick off?

And then spend some time running through some models to see whether that amount is sustainable. So, use a tool like Morningstar's Asset Allocator. There are lots of different retirement income tools on the web, kind of stress-test that plan withdrawal rate to see whether that's going to be doable and plan for a nice long life expectancy as well while you do that stress test.

Stipp: So, this is ETF Week, and if we're going to focus on how you'll put together a portfolio of ETFs that you could use after you figure out those income needs, how would you start to put it together? What different sorts of buckets might you use in order to put this approach into action, using ETFs?

Benz: It does get back to that bucket approach, Jason, which I think can be really powerful. So, the simple idea is that you've got bucket number one which is holding maybe zero to three years worth of income needs.

So, maybe you've got a true cash piece to that bucket number one and then maybe you've also got a very high-quality short-term bond fund, such as Vanguard Short-Term Bond ETF. That's bucket number one; that's what you're going to be drawing on for years zero through three of your retirement living expenses.

Stipp: So these are really short-term buckets, as we said before, they're not really going to be giving you much income. Really you're depending on those for the stability of the portfolio and those short-term needs, correct?

Benz: Right, because you don't want those assets to be gyrating around while you pull them out. You can maybe pick up a little bit of income with the short-term bond index ETF, but the idea is just to keep things stable. That's why this isn't a huge part of the portfolio, because it's not going to do a lot for you, but preserve your purchasing power possibly.

Stipp: Okay, so then when you start to think beyond those immediate one- to two- to three-year needs, how do you start to structure the rest of the portfolio that's looking out a little bit further?

Benz: Right. So, maybe the middle bucket that would cover you for years four through 10 of your retirement, this could hold high-quality dividend-paying stocks. So I know one ETF our analysts like a lot is Vanguard Dividend Appreciation, and also a good quality intermediate-term bond fund. You could go at this with a single vehicle, like a total bond market index ETF or you could mix-and-match a little bit. I know our ETF analysts aren't too keen on the heavy government-bond exposure that comes with a total bond market ETF, so you could possibly take a mortgage-backed ETF and marry it with a high-quality corporate bond ETF as well to kind of simulate that exposure without the big dose of government bonds. So that's kind of the intermediate-term piece.

Stipp: And we know that retirement also can be a long-term prospect. We also hope that it would be a long-term prospect. What about that longer-term, maybe 10-year, 15-year, 20-year--what could you put together with an ETF portfolio to meet those longer-term needs?

Benz: So years 10 and beyond could encompass some of your riskier assets. So you could have a total stock market, total international stock market ETF in there, get a little bit of currency fluctuations with that piece. To the extent that you have a small slice of the portfolio in a commodities ETF, that could also go in that year 10 and beyond piece. And also maybe a total U.S. stock market index ETF, which would give you a little bit of mid- and small-cap exposure. You could also look at a dedicated small- and mid-cap ETF, one of the extended-market ETFs would work well there.

Stipp: So we talked about how you might arrange the portfolio, which buckets, what kind of ETFs you might put into them. Another consideration for retirees is where they put these different assets, so I mean what kind of accounts; there are taxable accounts, there are tax-advantaged accounts. How do you put tax in the mix as you are thinking about the way that you start to withdraw money from these accounts?

Benz: So, there are two key considerations: asset location and then sequencing those withdrawals so that you are preserving some of those tax benefits of the tax-deferred and tax-sheltered vehicles.

The key thing to know about sequencing those withdrawals is that you want to get rid of things that are costing you the most tax-wise or otherwise first. So, if you are over 70 and a half and taking required minimum distributions from your portfolios, you obviously want to take those, because you'll pay big penalties if you do not. Then move on to your taxable accounts in terms of deciding which to tap next, and the reason is that you will pay ongoing tax costs to hold that money in taxable accounts.

You want to hang on to things with tax sheltering benefits, anything that gives you tax deferral or certainly tax-free withdrawals--hold on to that stuff until last, because those will be your most beneficial.

Stipp: Extend those benefits for as long as you can.

Benz: Exactly.

Stipp: The last thing that I wanted to ask you about: So, this process of the bucketing approach, as you get it set up and running, and as you are executing it throughout your retirement, you will need to be moving some funds from different buckets. So from the longer-term buckets, some of those funds will eventually need to come into the mid-term, and the mid-term to the short-term as you deplete those buckets. It sounds like it could get a little cumbersome. How can I set up a process that maybe makes it a little bit easier?

Benz: This is why financial planning guru Harold Evensky says, he just likes two buckets--one short term, one the other stuff--because this can get really cumbersome. So, I've heard from people who have as many as seven or 10 buckets. That gets to be quite a process to keep these things up-to-date, and you do periodically have to refill that cash bucket as you deplete it.

So, I think for a lot of investors putting this on a regular schedule, knitting it into your rebalancing process--so if you find that you need to make some asset allocation tweaks, possibly making this bucket maintenance part of that process can make a lot of sense.

Other investors I talk to like to be more tactical. So, they like to lighten up and sell those things that they wanted to sell anyway because maybe there was a manager change or something going on in an investment that made it fundamentally unattractive. So, it's a matter of personal opinion.

But if you are trying to be hands-off, that more mechanistic approach where you say, "I do bucket maintenance every December and get my asset allocation back in line," I think that will be the easiest hands-off approach for most retired investors.

Stipp: All right, Christine. Thanks for the tips on the importance of having a total return approach in retirement, especially in today's environment. Thanks for being here today.

Benz: Thank you, Jason.

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

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Jason Stipp  is Editor of, the sister site of

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