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INSIDE: CHRISTINE BENZ’S ESSENTIAL GUIDE TO RETIREMENT PLANNING EARLY PLANNERS

Smart ways to start small and build on your goals / 8

MID-CAREER PLANNERS

t r a m s e g n a ch

Reboot your savings potential with HSAs / 11

PRE-RETIREES

Improve your retirement outlook after a shortfall / 12

YOUR FINANCIAL FUTURE POWERED BY:

RETIREES

How to make money last once your income is fixed / 18

WARNING: RETIREMENT WITHDRAWAL MISTAKES PAGE 13

21 DAYS     Breaking down your tasks can help you reach your investment goals EXP INSIGEHRTT S

“To change one’s life, start immediately, do it flamboyantly, no exceptions.”  WILLIAM JAMES

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BY CHRISTINE BENZ, MORNINGSTAR INC.

illiam James, a psychologist, was right on the money with the “immediate” part. But does enacting lasting change in your life need to be momentous or flamboyant? Nah. Instead, most people who have achieved big goals will tell you they’ve done so little by little, one small step at a time. The person who lost 30 pounds did so by walking an extra mile a day and putting skim milk in her coffee instead of half and half. The author who wrote a best-selling first novel got it done by writing a few pages each night, after he put his kids to bed.

The same is true when you’re aiming to achieve your investing goals. The broad goals of funding a comfortable retirement, paying for college or buying a first home can seem daunting, particularly when you think through the dollar amounts that you’ll need to save.

But if you break these broad goals down into smaller, more manageable tasks, and tackle them one at a time, you can begin to make real progress toward your goals.

In this article, I’ll coach you on completing one investment task per day, with an eye toward getting in the best financial shape of your life. I’ll discuss how to invest for goals that are close at hand, how to build a retirement portfolio, and how to make sure your investments are on track from year to year. In just a few weeks, you can be financially fit!

DAY 1: START TRACKING YOUR EXPENSES

Degree of difficulty: Easy Let’s start with a fairly easy task: begin to track your spending habits. There are Web sites, apps and financial software programs devoted to helping keep close tabs on your household’s cash flows, but tracking your expenses can be as simple as jotting them down whenever you find yourself opening your wallet or writing a check. Group your expenses into one of two main categories: fixed (i.e., spending that doesn’t change and you can’t do without) and discretionary.

Plan to keep track of your expenses for at least a month; that way you can identify patterns in your spending and zero in on your problem spots. Examining cash flows in this way is the first step in creating a budget that aligns with your priorities and the realities of your life.

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INSIDE

EMERGENCY? DON’T PANIC! Four simple steps to setting up a backup fund / 9

THE SMARTER WAY TO WORK Tips to make your career less of a chore after you age / 19

POWER UP YOUR PAY

Bring a bucketed approach to portfolio management / 16

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MARCH 2019

INVESTMENTS CONTINUED FROM PAGE 1

DAY 2: TAKE STOCK OF YOUR ASSETS AND LIABILITIES

COMMENTARY

by Christine Benz

Crafting a satisfying financial plan Your future can be satisfied by the right plan

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ou’ve probably heard about studies showing that the typical American spends more time researching vacation destinations than crafting a financial plan. And let’s be honest here: Did financial planning even have a chance?

After all, thoughts of vacation are happy ones, whether your idea of a good trip is a trek in the Himalayas or lying on the beach with the sole occupation of keeping sand out of your cocktail.

Financial planning, meanwhile, conjures up drudgery for most of us: spreadsheets, calculators, financial statements — in short, something that feels a whole lot like our day jobs.

For many, the thought of getting elbow-deep in their finances feels even worse than a day job — probably not surprising given that we’re coming through a period of stagnant wage growth for most earners, a housing market bust and two major bear markets over the past few decades.

But I think there’s another reason people get into vacation planning more than they do their financial lives. The former is one and done: Spend a few hours researching potential spots, consult with fellow travelers on the plan and book it. At the end, you have a feeling of satisfaction and something to look forward to.

Crafting a financial plan, meanwhile, is not one and done at all. It’s a process, something that you’re going to have to keep toiling with for the rest of your life.

But does it have to be that way? I’d say no. Individuals can bring a bit of “one and done” gratification to their financial plans by tackling their key financial tasks one at a time rather than viewing them as a time-sucking, soul-crushing black hole of obligation.

Helping you cross some of those key financial planning tasks off your list is the focus of this supplement. Harnessing research and guidance from Morningstar.com, this guide is designed to help you knock off many specific financial planning jobs, one by one.

Some of these tasks fall into the category of financial-planning 101 — crafting a budget and making sure you have an adequate emergency fund, for example. Others, such as reducing the drag of taxes on your portfolio or testing retirement readiness, are appropriate for more seasoned investors.

If you feel like you’re in good shape on one of the tasks or it’s not relevant to your financial life, you can move on to the next one. And even if you don’t make it all the way through, our goal is that you’ll end up more financially fit than you started out.

As always, you can count on Morningstar guidance to be objective — that is, we don’t have a vested interest in whether you choose to do business with one financial provider over another, or whether you buy individual stocks, mutual funds or exchange-traded funds.

The goal of this supplement, and all of our work on Morningstar.com, is to help individual investors improve their financial well-being so they can enjoy the nonfinancial parts of their lives. Like vacation.

Christine Benz is director of Personal Finance at Morningstar Inc.

smarte chang

Degree of difficulty: Moderate Now that you’re getting warmed up, it’s time to move on to the key task that will show you how you’re doing financially: checking up on your net worth.

If you keep good records and don’t have many financial accounts, enumerating your assets and liabilities will be pretty straightforward and shouldn’t be time-consuming. You’ve got more work ahead of you if your records and portfolio are in a state of sprawl, but think of this as your impetus to streamline and get organized.

You don’t need to get especially fancy. To document your assets, simply retrieve your latest account balances and estimate the worth of your personal possessions, including real estate. On the other side of the ledger, record any debts you owe, including your mortgage, student, home equity or auto loans, and credit card balances. Subtract your liabilities from your assets and you’re looking at your net worth.

If your net worth is negative or barely positive, you’ve got your work cut out for you. Creating and sticking to a budget should be a key priority in the years ahead. And even if your net worth is comfortably positive, you still should spend time digging into the numbers.

Is most of your money tied up in a single asset, such as company stock or your house? If so, a key goal should be to diversify your financial assets in the years ahead. Do you have an adequate amount — six months’ worth of living expenses at a minimum — stashed in an emergency fund? If you don’t, prioritize building up your position in ultrasafe (and unfortunately, ultra-low-yielding) investments before investing in longer-term assets like stocks.

DAY 3: CHECK YOUR EMERGENCY FUND

Degree of difficulty: Easy Before you begin saving for your long-term goals, it’s crucial that you build an emergency fund — a basket of ultra-liquid investments that you can tap in case you lose your job or confront an unanticipated car or home repair.

The typical rule of thumb is to keep three to six months’ worth of living expenses in your emergency fund. But perhaps a better way to decide how much to store in cash is to think about how much of a cushion you’d like to have in case you lost your job. If you go through that exercise, you’re apt to conclude that three months’ worth of living expenses is nowhere near enough. But don’t go overboard with your cash hoard, either.

After all, interest rates on money market accounts and funds are low, so being too conservative has an opportunity cost.

As you calculate your emergency-fund requirement, don’t use your real spending patterns to set your living expenses.

Think about how much you could get by on in a pinch, excluding dinners out, house cleaners and vacations.

Compare your emergency-fund target with the amount you have saved in CDs, money market accounts and funds, and checking and savings accounts. Don’t include cash holdings that appear in long-term mutual funds.

Building your emergency fund up to your target level should trump saving and investing for other goals, such as retirement or college.

DAY 4: GET MAXIMUM MILEAGE FROM YOUR CASH HOLDINGS

Degree of difficulty: Easy to moderate Everyone needs cash, both for an emergency fund and to cover upcoming expenses such as your property tax bill or college tuition. Keeping that money safe is important, but the big drawback is that yields on CDs, money market accounts and other cashlike vehicles often are low.

When shopping for the best yields on cash investments, the list of don’ts is almost as long as the list of dos. While it’s smart to be opportunistic and scout around for the best yields, my key piece of advice is not to get too cute. Safety is key for this portion of your portfolio, so resist the temptation to park some or all of your assets into a “cashlike” vehicle that offers a higher yield but also a greater risk to your principal.

Ultrashort-bond funds and bank-loan funds are a great example of why you shouldn’t chase yield: Although some investors had used funds in both categories as a higher-yielding money market substitute, the average fund in these groups lost 8 percent and 30 percent, respectively, in 2008’s flight to quality.

CDs usually offer higher yields than money market funds and other cashlike vehicles, and they offer FDIC protection to boot. The big drawback is that you’re locking yourself into a fixed term and rate. Money market mutual funds, bank-offered money market accounts and high-yield savings accounts offered by online banks and credit unions can buy new, higher-yielding securities if rates move up.

If you’re in a high tax bracket, another

PUBLISHER John M. Humenik, Vice President/News and CCO, Lee Enterprises

option for your cash is a municipal money market fund, whose income will be free of federal income tax. Most fund companies have a tax-equivalent yield function on their bond calculators that can help you determine whether you’re better off in a muni or taxable money market fund once the tax effects are factored in.

DAY 5: MAP OUT YOUR FINANCIAL GOALS

Degree of difficulty: Easy Most of us have a running list of financial goals: whether it’s paying off our homes, financing college for the kids and grandkids, funding a comfortable retirement or paying for here-andnow creature comforts like vacations and new cars. Few people, however, take time to document their goals and quantify exactly how much they’ll cost, even though that step is key to helping you set your household’s financial priorities. It’s also pretty easy.

Today, take a moment to jot down your goals. Group them into one of three bands: short-term goals (goals you’d like to achieve in five or fewer years), intermediate-term goals (five to 15 years from now), and long-term goals (15 years or more in the future). Once you’ve done that, prioritize your goals within each time frame. Be sure to include debt retirement on your list of goals.

The next step is to estimate exactly how much those goals will cost you. If your goal is close at hand, such as buying a car next summer, quantifying it is straightforward. But if it’s a goal that’s further in the future or one that you’ll pay for over several years, the calculation may be more complicated and you’ll also have to factor in inflation.

FinAid’s College Cost Projector (finaid. org) can help you calculate the cost of college using historic (and historically scary) inflation rates, and Bankrate’s Retirement Calculator (bankrate.com) shows you how much you’ll need to save for retirement. Morningstar.com’s Savings Calculator is a multipurpose calculator that helps you see the interplay between your current savings, future contributions, and your expected rate of return.

DAY 6: ALLOCATE CAPITAL LIKE A PRO

Degree of difficulty: Moderate to difficult Although Morningstar focuses on helping you invest in stocks, funds and

EDITOR Ben Cunningham, Director of News Presentation, Lee Enterprises

DESIGNER April Burford, Lee Design Center

exchange-traded funds, the reality is that investors’ highest-impact decisions precede the decision to invest in the market. Do you save enough? And when you have extra cash on hand, do you pay down debt, invest or do a little of both?

When it comes to the latter decision, it’s helpful to think of yourself as a business owner, steering your cash toward the opportunity that is apt to offer you the best return on your capital.

Paying off debt — even more benign types of debt like mortgage debt or student loans — offers you a knowable return on your money, which is always a good thing. If you’re receiving a tax break on your debt, as is the case with some mortgages and student loans, you’ll get less of a bang out of paying off the note prematurely. However, it’s worth noting that recent changes to the tax code — including higher standard deductions and new limits on the tax-deductibility of mortgage interest — mean that fewer taxpayers will receive a significant tax break from carrying a mortgage than was the case before.

Investing in the market offers a potentially higher rate of return, but the hitch is that return, unlike paying off debt, isn’t guaranteed. When forecasting returns for your investments, be conservative. I usually use a 6 percent rate of return for equities, a 2 percent return for bonds, and a 1 percent return for cash.

Based on the asset mix of your portfolio, you then can forecast a ballpark return for it. Armed with that information, you then can determine whether investing in the market or paying off debt is the best return on your dough.

DAY 7: INVEST FOR MID-TERM GOALS

Degree of difficulty: Moderate Yes, yields on truly safe investments like CDs and money market funds often are shrimpy. But if you’re building an emergency fund or saving for a goal that’s close at hand, the risks of venturing beyond ultra-safe investments outweigh any extra yield you’re able to pick up. It’s boring, but you’ll need to rely on your own savings, rather than investment returns, to do the heavy lifting in these instances.

But what if you’re saving for an intermediate-term goal and don’t expect to need the money for another couple of years or even more? In that case, you can tolerate modest fluctuations in the

Content featured in this section was gathered from resources associated with Morningstar Inc. and Tribune Content Agency.

MARCH 2019

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INVESTMENTS DAY 11: CHECK UP ON THE QUALITY OF YOUR COMPANY RETIREMENT PLAN

value of your principal. A core intermediate-term bond fund can fit the bill. A few favorites among Morningstar analysts include Dodge & Cox Income (DODIX), Fidelity Total Bond (FTBFX), and Metropolitan West Total Return Bond (MWTRX).

If you have an even longer time horizon — anywhere between five and 10 years — you can hold stocks as well as bonds. Morningstar analysts like Vanguard Wellesley Income (VWINX) and Dodge & Cox Balanced (DODBX), which combine stocks and bonds together. If you hold one of these funds and are getting close to needing money to fund your goal, you can transition the assets to cash for safe-keeping.

DAY 8: IDENTIFY THE RIGHT VEHICLE FOR COLLEGE SAVINGS

Degree of difficulty: Moderate As with retirement investments, the college-savings landscape is far more cluttered and complicated than it needs to be, with myriad vehicles competing for investors’ attention.

Due to their generous contribution limits and the potential for tax-free withdrawals, section 529 college-savings plans have emerged as the vehicle of choice for families looking to sock away a substantial sum for school. 529s have generally improved substantially in the past few years, with costs coming down and the quality of investment options going up. To see how these college-savings plan compare, consult Morningstar’s annual 529 Plan Ratings (morningstar.com/save-for-college.html).

Some investors, however, would like to invest for their kids outside the confines of a dedicated college-savings vehicle like a 529 or Coverdell Education Savings Account. If that’s you, you have a couple of different options. Setting up a UGMA/ UTMA account is one simple way to go, but the drawbacks probably outweigh the pluses, in my view.

The assets become the property of the child once he or she reaches the age of majority (varies by state but usually age 18 or 21), when some young people may not yet be equipped to make good financial decisions. And if you’re pretty sure your child is college-bound, you should know that those UGMA/UTMA assets will work against your child in financial aid calculations.

For those reasons, investors looking to save outside of a dedicated college-funding vehicle like a 529 or Coverdell should consider saving for their kids in one of a couple ways. The first simply would be to hold tax-efficient investments, such as low-turnover exchange-traded and index funds, individual non-dividend-paying stocks, municipal bonds/ funds or tax-managed mutual funds, within the confines of the parents’ taxable account. Withdrawals won’t be

tax-free, as is the case with qualified withdrawals from a Coverdell or 529, but it’s straightforward and investors gain the added flexibility to use the money outside of college expenses — penalty free — if the need arises.

Another option is to use a Roth IRA to save for your kids. In a Roth, you can pull out your contributions (not your gains), tax-free, at any time and for any reason, making the vehicle a great multi-tasker for those looking to save for retirement and college at once.

The key drawbacks? Roth contribution limits are pretty low — currently $5,500 for those under 50 and $6,500 for those over — and pulling money out for your kids leaves less money at work for retirement.

DAY 9: INVEST YOUR COLLEGE-SAVINGS ASSETS

Degree of difficulty: Moderate The bear market of 2008 forced many retirees and pre-retirees to recalibrate their plans and, in some cases, to make meaningful reductions in their spending.

But it also had a huge impact on another, much younger group: college-bound students.

Unfortunately, many college-savings plans, including several professionally run 529s, were far too skewed toward stocks in the later stages of their investment paths at that time, resulting in big savings shortfalls for students getting close to college.

If that experience had a silver lining, though, it was that it underscored the importance of holding on to what you already have versus gunning for big returns in your child’s college-savings plan, particularly as college draws near.

Many of the investment pros running 529 college-savings programs have scaled back the equity holdings of their age-based options to make them more conservative, and they added index funds in place of poorly chosen actively managed funds, in the hopes of reducing the risk of a big shortfall at the worst possible time.

Investors managing the asset allocations of their own college-savings programs also should take the lessons of 2008 to heart. Here are a few quick tips: ! By the time your child hits the teenage years, more than 50 percent of his or her college fund should be in bonds and cash. ! By the time your child is a junior or senior in high school, equities should compose only a small slice (less than 20 percent) of his or her college dough.

If you have to boost your college savings using a combination of financial aid, student loans or work-study, it’s better than risking the money you have been able to set aside.

DAY 10: DECIDE BETWEEN ROTH AND TRADITIONAL CONTRIBUTIONS FOR RETIREMENT SAVINGS

Degree of difficulty: Moderate Investors who are socking money away for retirement are apt to hit a fork in the road: Should they make traditional or Roth contributions? Investors in a traditional 401(k) will be able to contribute pretax dollars to their accounts; investors in a traditional IRA may be able to deduct their contributions if their income falls below the income limits. Investors in both traditional 401(k)s and IRAs also can take advantage of tax-deferred compounding. That sounds compelling, but the downside of building traditional 401(k) or IRA assets is that the money is taxable upon withdrawal in retirement.

Roth contributions, whether to a 401(k) or IRA, receive exactly the opposite tax treatment: There aren’t any tax breaks on contributions, but the money compounds on a tax-free basis and may be withdrawn in retirement without any taxes, too. (There are no income limits on 401(k) contributions, either Roth or traditional, but income limits apply to Roth IRA contributions. Single taxpayers can make at least a partial Roth IRA contribution if their income is less than $135,000; for married couples filing jointly, that threshold is $199,000.)

The right answer rests on one big swing factor: whether you expect to be in a higher tax bracket in retirement than you are now. But unless you’re quite close to retirement, the answer to that question is all but unknowable.

However, a few categories of individuals are good candidates for making all or at least part of their 401(k) contributions Roth-style. The first would be younger savers who aren’t earning a lot currently but may do so in the future. For them, their own earnings trajectory, plus the possibility that future tax rates will trend higher across the board, make a strong argument for a Roth 401(k) and IRA. Another good candidate for Roth assets is the upper-income individual who has a lot of retirement assets sitting in a traditional 401(k) and/or IRA. Opting for Roth contributions or even undertaking a conversion can give such individuals the opportunity to hedge their bets: If tax rates trend higher in the future, or they’re in a higher tax bracket in retirement than they were in their accumulation years, they’ll be glad they took the hit by making Roth contributions when tax rates were lower. On the flipside, investors who haven’t saved much for retirement and can make a deductible traditional IRA contribution may be better off with that type of IRA. It’s unlikely that their tax bracket will be higher than it is when they’re working, so they’re better off pocketing the tax break now.

Degree of difficulty: Moderate to difficult If you’re earning a match on your 401(k) plan contributions, it’s a nobrainer to invest at least enough to earn the match. But what if your company isn’t matching, or if you’d like to make a larger contribution to your retirement than you’re being matched on? Is it best to stick with the 401(k) or turn to another vehicle like a Roth IRA? The answer to that question depends, at least in part, on the quality of your plan. To help determine whether your plan is worth investing in or a is a stinker, ask your HR administrator for a document called a Summary Plan Description, which lays out crucial information about your 401(k).

Beware: This document is apt to be crammed with legalese and not likely to be easy reading. But after a little bit of hunting, you should be able to locate your plan’s administrative expenses.

These fees may be depicted in percentage or dollar terms; if the latter, divide your plan’s costs by the total dollars in the plan. If your plan doesn’t have any additional administrative costs, that’s a good sign. But if it layers on additional administrative fees that amount to 0.50 percent or more per year, that’s a red flag that your plan is a costly one. Check to see whether your plan includes other bells and whistles, such as a brokerage window, which allows you to invest in options outside the plan; the ability to take a loan; and the ability to make Roth 401(k) contributions.

After that, conduct a quick checkup of the breadth and quality of your plan’s holdings using the data and Analyst Reports on Morningstar.com. Look for a good array of core-type funds: large-cap U.S. and foreign stock offerings, balanced funds and core intermediate-term bond funds. For stock funds, look for expense ratios of less (preferably much less) than 1 percent per year, though specialized funds like international and small-cap offerings may charge a touch more. For bond funds, expense ratios of less than 0.75 percent are ideal.

If your plan checks out well on the above measures, funding it up to the maximum allowable level is apt to be a good use of your cash, thanks to the tax-deferred compounding that company-retirement plans afford. Before doing so, however, you also should deploy some of your retirement assets into an IRA. You can start and maintain an IRA with very low to no administrative expenses, and you also can access a broader range of investments than you can when investing inside of a company retirement plan like a 401(k).

DAY 12: MAXIMIZE YOUR MATCH

Degree of difficulty: Easy If you’re not earning any matching funds on your 401(k), my usual advice is to fund an IRA up to the maximum allowable level first. The reason is that you can put any investment you’d like into an IRA, and you won’t have to pay any additional administrative expenses to invest in one, in contrast with many 401(k) plans. IRA investors also enjoy tax breaks that parallel 401(k)s. If you find yourself with additional assets to invest after that, turn to your 401(k) (provided it’s a good one).

If you are lucky enough to earn matching contributions on your 401(k), plan to take advantage of each and every one of those dollars. This is particularly relevant if you’re highly compensated and/ or you expect to receive a large bonus early in the year. That’s because many companies make matching contributions throughout the year, but if you hit your allowable 401(k) contribution well before year-end, you won’t be able to take full advantage of any matching contributions your employer would’ve made in the remainder of the year. (Some companies make an adjustment to help employees receive a match on their full 401(k) contributions regardless of when those contributions were made, but others do not.)

If this is a potential issue for you, you’ll need to lower your contribution rate per paycheck to ensure that you don’t reach your maximum contribution too early in the year. People who receive large bonuses may be especially vulnerable to missing out on matching contributions; they usually can correct this issue by lowering the percentage of their bonus that goes toward their 401(k).

DAY 13: USE AN IRA TO IMPROVE YOUR PORTFOLIO

Degree of difficulty: Easy If you have most of your retirement assets in a company-retirement plan and are using an IRA to supplement what you already have, you can use your IRA in one of two ways.

You can hold core-type investments, which tend to be mainstays in most 401(k) plans: index stock and bond funds, large-cap actively managed funds, balanced funds and so forth.

Alternatively, you can use your IRA to fill holes in your company retirement plan. For example, say your plan includes adequate stock funds, but its bond funds charge more than 1 percent per year in annual expenses — sure to cut into your long-term returns. If that’s the case, you can fill your company retirement plan with the decent stock funds and leave the bond CONTINUED ON PAGE 4

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INVESTMENTS CONTINUED FROM PAGE 3 portion of your portfolio to an IRA. Morningstar’s Instant X-Ray tool (morningstar. com) can help you see where you’ve got holes in your existing asset mix.

You also can use your IRA to include asset types not commonly found in company retirement plans, including funds dedicated to real estate investment trusts, commodities or Treasury Inflation-Protected Securities. All of these investment types do a good job of diversifying a portfolio that’s composed primarily of conventional stocks and bonds. They also can be a headache when held outside of tax-sheltered accounts, because they generate a lot of taxable income. So, they’re ideal holdings for an IRA.

DAY 14: MANAGE YOUR PORTFOLIO FOR TAX EFFICIENCY

Degree of difficulty: Moderate Although utilizing tax-sheltered vehicles like IRAs and 401(k)s can help you dodge the tax collector, at least temporarily, there are occasions when you’ll need to save in your taxable accounts.

Perhaps you’re socking money away for a goal that’s close at hand, for example, or maybe you’ve maxed out your contributions to the tax-sheltered vehicles available to you.

If that’s the case, there still are some steps you can take to reduce the tax effects on these investments.

One of the key steps you can take is to limit your own trading activity, thereby reducing the taxable capital gains you’ll owe from year to year. I’m also a big fan of actively pruning your taxable portfolio’s losers, which helps you offset capital gains from your winners. Single taxpayers with incomes below $38,600 and married couples filing jointly with incomes below $77,200 can do the opposite, pre-emptively selling their long-term gainers and immediately re-buying them.

The advantage of that strategy is that it’s tax-free, as investors below those income thresholds pay a 0 percent rate on longterm capital gains, and it also increases the investor’s cost basis in her holdings.

Finally, it pays to be careful about what types of investments you hold in your taxable accounts. High-turnover stock funds, whose short-term capital gains are taxed as ordinary income, are a definite “don’t,” as are high-income-producing investments such as REITs and junk-bond funds.

On the “buy” list for taxable investors are low-turnover exchange-traded funds and index funds, municipal-bond funds, individual stocks and tax-managed funds.

DAY 15: CONDUCT A “QUICK, DIRTY” PORTFOLIO CHECKUP

Degree of difficulty: Easy to Moderate A good starting point for a portfolio checkup is to take a snapshot of where your total portfolio is right now, with an eye toward flagging any notable trouble spots. The best tool for the job is Morningstar’s Instant X-Ray tool, which you can find at morningstar.com. Simply plug in tickers for each of your holdings (use CASH$ for cash), then hit “Show Instant X-Ray” for a look at your portfolio’s stock/bond/cash mix and breakdown by investment style, sector, and geography.

That’s a lot of information, and it may not be valuable without some context. To help make sense of what you’re looking at, click on the “Interpreter” tab under “Edit Holdings.” As you do so, run through the following checklist and take notes as you go along: 1. Is your stock/bond/cash mix in line with your targets? Take note if your allocation to any one asset class is more than five or 10 percentage points higher or lower than your targets. If it is, it’s time to rebalance.

2. Are you making big, inadvertent sector bets? Compare your weightings to the S&P 500’s (provided in X-Ray).

Again, look for big bets of five or 10 percentage points or more.

3. How about investment-style bets?

To help provide a reference point, the Dow Jones Wilshire 5000 Index, a measure of the broad market, recently had the following breakdown in the Morningstar style box: 25 percent in each of the large-cap boxes, 6 percent in each of the mid-cap boxes, 3 percent in small value, 3 percent in small blend and 2 percent in small growth.

4. Is a big share of your portfolio in a single stock? To see, click on the Intersection tab. Positions amounting to 5 percent or more of your total portfolio can ramp up its risk level.

5. Do you have an adequate emergency fund? Make sure you have a bare minimum of three months’ worth of living expenses in a cash or cashlike vehicle.

(Don’t use X-Ray to gauge your cash holdings because it is likely to overstate them by including cash holdings that appear in long-term mutual funds; you couldn’t access that cash without selling the whole fund, so that money isn’t really liquid.)

If you have extra time, click the individual security names at the bottom of the main X-Ray page to see data and analyses for the stocks, mutual funds, and ETFs in your portfolio.

DAY 16: LOOK FOR OPPORTUNITIES TO STREAMLINE

Degree of difficulty: Moderate Today’s task is one that’s relevant to investors of all ages and of all life stages: combating portfolio sprawl.

Diversification is a good thing, of

course, but you can also overdo it. It requires time and research to keep track of important developments at stocks and funds, and that task is compounded when you have many different accounts.

And the more investments you have, the greater the likelihood that your portfolio will behave like the market.

There’s nothing inherently wrong with market-like performance, but you don’t want to have to pay active management fees when an index fund would have done the job just as well.

So what are some strategies for beating back the sprawl? Index mutual funds and exchange-traded funds that track a broad market segment are a good place to start if you’re trying to streamline your financial life; Morningstar’s fund pick lists include plenty of topnotch core index options.

Alternatively, you could take advantage of all-in-one options, either by using a target-date fund or a stock/bond hybrid fund. And if you’re managing multiple accounts geared toward a single goal — for example, you and your spouse each have IRAs and 401(k)s, as well as taxable assets earmarked for retirement — think of them as a single entity rather than running each account as a well-diversified whole. Doing so gives you the freedom to pack a significant share of your assets into the best investments available to you within each account.

Use Morningstar’s Instant X-Ray tool to make sure the whole portfolio is diversified and that the asset allocation is in line with your target.

DAY 17: SEE IF YOU’RE ON TRACK FOR RETIREMENT SAVINGS Degree of difficulty: Moderate Most of the tasks in my 21-day financial fitness regimen have centered on helping you get your investment program up and running. But once you do, it’s essential that you periodically check in to make sure that your portfolio and your savings rate put you on track to help you meet your goals.

One way to gauge whether your retirement plan is on track comes courtesy of Fidelity Investments. The firm recommends that investors in their 30s have retirement savings equal to their current salaries, those in their 40s have saved three times their current salaries, those in their 50s have saved six times, and those in their 60s have saved eight times their current salaries.

For investors who are closing in on retirement and want to gauge their portfolio’s viability to supply their in-retirement income needs, they can simply multiply their current balances by 0.04.

If that amount, plus any predictable income they’ll be able to rely on through Social Security and/or a pension, is sufficient to live on, they’re likely on the right track. (Retirement researchers have found that withdrawing 4 percent of a retirement portfolio’s balance in year 1 of retirement, then inflation-adjusting that dollar amount in subsequent years, gives a balanced portfolio a good shot of lasting for 25-30 years.)

Those are just rules of thumb, though.

A financial adviser can provide a more precise read on the viability of your investment program, and can help you tweak it based on your own situation.

Alternatively — or perhaps in addition to customized financial advice — you can turn to online tools to gauge the sufficiency of your retirement assets. T. Rowe

Price’s free Retirement Income Calculator (troweprice.com) is one of the most comprehensive. You’ll be prompted to enter some information about yourself — your birth date, your expected retirement date, your current asset level and allocation, and your desired level of income in retirement. (You won’t be asked to provide any personally identifying information, such as your name or Social Security number, though, so don’t worry about anyone contacting you with a sales pitch.) The calculator will then give you a gauge of whether your portfolio in its current incarnation will support your desired level of income.

The bottom line with all of these tools is that they help you assess whether your portfolio can realistically support your goals. And the sooner you make that determination, the better positioned you will be to make changes so you don’t fall short.

DAY 18: GET A PLAN FOR YOUR PORTFOLIO AS YOU NEAR RETIREMENT

Degree of difficulty: Moderate Amassing enough assets to retire is the heaviest lifting that any of us will do in our investing lives. But even after you’ve cleared that hurdle, it’s still important to have a plan for managing your assets during retirement.

Because encountering a bear market early in your retirement years can have a devastating impact on portfolios that are too aggressively positioned, it’s a sensible idea to start moving a portion of your portfolio to safer securities like cash and bonds as retirement draws close.

Another key task for retirees and pre-retirees is to determine a realistic portfolio withdrawal rate. How much can you take out without running the risk of outliving your assets? There aren’t any one-size-fits-all answers, but many planning experts agree that a 4 percent initial withdrawal rate, combined with ongoing adjustments to account for inflation, is sustainable with a 60 percent equity/40 percent bond portfolio over a 25-year retirement period. However, retirees with longer time horizons and/ or more conservative equity allocations should take more modest withdrawals.

It’s also a good idea to adjust your withdrawal rate downward if you encounter a weak market; that way, more of your portfolio is in place to recover when stocks do.

Finally, if you’ve saved for retirement in various accounts — and most of us have — your retirement portfolio strategy must also include a plan for tapping those assets. As a general rule of thumb, you’ll want to tap your taxable accounts first, deductible IRAs and company-retirement plan assets second, and Roth assets last. If you’re subject to required minimum distributions, fulfilling those distributions comes first.

DAY 19: USE A ‘BUCKETING’ SYSTEM WHEN CONSTRUCTING YOUR RETIREMENT PORTFOLIO

Degree of difficulty: Moderate to Difficult One of the most daunting aspects of managing your finances is figuring out how to transition from accumulation mode into retirement, or “harvest” mode.

One intuitive way to construct a retirement portfolio is to create various buck-

ets of money based on when you expect to tap them for living expenses. Bucket number one contains living expenses for the next 1 to 2 years, and therefore should consist of highly liquid investments like CDs and money market funds. This is money you can’t afford to lose.

Bucket number two should be positioned for living expenses in years 3 through 10, and therefore you can afford to take on slightly more risk. Intermediate-term bond funds and even conservative stock funds or balanced fund are good choices for the intermediate sleeve of your retirement portfolio.

Those assets you don’t expect to tap for at least 10 more years can be stashed in stocks and stock mutual funds. Because you’ve established you have a fairly long time horizon for this money, you won’t be unduly upset if the stock market has periodic hiccups.

DAY 20: MAKE SURE YOUR RETIREMENT PORTFOLIO INCLUDES INFLATION PROTECTION

Degree of difficulty: Easy If you’re already retired or getting ready to do so, one of the key risks that you’ll need to guard against is inflation.

Social Security payments are adjusted for inflation (assuming the Consumer Price Index is going up), but the paychecks you’ll take from your retirement portfolio will grow smaller and smaller — in real terms — as the prices on the stuff you buy trend up. It’s therefore important to position your portfolio to address that threat.

Although investors often debate the best investments to guard against inflation, with some favoring so-called hard assets like commodities and gold, Treasury Inflation-Protected Securities (TIPS) provide the most direct way to do so. The principal values of TIPS adjust upward to keep up with inflation, as measured by the Consumer Price Index, giving investors a straightforward, lowcost way to ensure that their portfolios keep up with higher prices. I-Bonds, which can be purchased directly from the U.S. Treasury, have similar inflation-defending features. (In contrast with TIPS, however, I-Bonds receive an adjustment to their interest payments to account for inflation.)

DAY 21: SCHEDULE REGULAR CHECKUPS

Degree of difficulty: Moderate Investors often make the mistake of checking up on their portfolios too frequently, or worse yet, only after big market moves, when they’re most inclined to make rash decisions. To help avoid that pitfall, schedule regular checkups in advance.

For most people, one comprehensive portfolio review per year is plenty, and much better than obsessing on a daily basis. Year-end — ideally around Thanksgiving, before the holidays gear up — is a good time to conduct your annual portfolio review, because you can still make adjustments to reduce your tax bill.

Morningstar.com’s Portfolio Manager makes it easy to monitor your portfolio on an ongoing basis. You can either enter your portfolio directly into the tool or via our Instant X-Ray tool. After you’ve viewed the X-Ray for your portfolio, simply click Save Instant Morningstar X-Ray as a Portfolio.

smart change

MARCH 2019

5

INVESTMENTS

When you’re worried about your money, you want to make it safe. However, you risk missing out on the next rally.

EXP INSIGEHRTT S

NO MORE INVESTING

MISTAKES

I

Don’t fret about daily ups and downs — and be sure to diversify

BY RUSSEL KINNEL

talk with investors almost every day, and over time the same themes emerge. Although they cover the gamut of sophistication levels, I hear the same mistakes over and over again. So, to help save you from repeating the same mistakes and losing a lot of money, I’ve jotted down 20 of the most common investing mistakes.

MISTAKE 1: Reacting to short-term returns Every day, people go to their online 401(k) accounts and sell the fund with the worst one-year returns and buy the one with the best one-year returns. It makes them feel better, and they will tell you that the new fund is ahead of the curve and run by a smart manager, and the old one has lost its touch. What they won’t say is that they are buying high and selling low. Nor will they say that short-term returns are just noise. You are better off buying funds with lagging short-term performance than those with top-quartile returns.

MISTAKE 2: Basing sell decision on cost basis You bought fund A at $10 and now its net asset value is at $5. You bought fund B at $10 and now it’s at $20. Which should you hold, and which should you sell? I have no idea.

The amount you paid is relevant only to tax planning. What matters is which will have better returns over your investment horizon. If the answer is fund B, then sell fund A (you’ll have a tax benefit if it’s in a taxable account) and put the proceeds in fund B. The problem is that people have an emotional attachment to the price. Some are afraid to book losses, and others are too anxious to sell a winner for fear that they’ll miss out on gains. What matters is whether the funds have strong fundamentals.

MISTAKE 3: Selling after the market falls The short-term direction of the stock market is unpredictable, yet selling in reaction to market moves implies that you can predict short-term moves. What we fail to account for is that the markets price in the same news that we are hearing — often before we hear it. The markets are not perfectly efficient from minute to minute, but they quickly reflect a best guess based on new information. Fear is one of the greatest enemies of successful investing. When you’re worried about your money, you want to make it safe. However, you risk missing out on the next rally, and you might not even keep pace with inflation. From a long-term perspective, cash is very risky and stocks are low risk.

MISTAKE 4: Accumulating too many niche funds We get mailings all the time telling

us about hot new investments. In 2007, commodity funds and BRIC (Brazil, Russia, India and China) funds were the rage and the timing turned out to be terrible.

These specialist funds are exciting and fun to buy, but they will mess up your portfolio if you let them. Most niche funds charge more than more-diversified funds, and they typically have third-tier managers and less analyst support. Yet you can get the same exposure to sectors and regions through more-diversified funds. Niche funds drive up your costs, add extra volatility and make managing your portfolio more difficult.

MISTAKE 5: Failing to build an overall plan This is a biggie. Spend a little time to spell out your goals, how you’ll meet them and the role of each investment.

This is an enormous help in figuring out how to get to your goals and how to adapt along the way. Make a little plan, and your day-today investment decisions will become easier and less stressful.

a handle on risk by looking at annual returns. In a bad year, the stock market can lose 30 percent or more. In a bad three-year period, it can lose 60 percent.

It’s reasonable to assume that nearly any stock fund can do at least that badly.

This is why stocks are for 10- or 20-year time horizons or longer. If you know that going in, you stand a much better chance of earning a healthy return. Most bond funds can lose 5 percent or 10 percent in a year. If they have long maturity or own mostly junk-quality bonds, you can double those losses or more.

MISTAKE 10: Not diversifying properly The 2008 bear market punished financials the most, while energy fared best.

Large growth got crushed in 2000–02, and small-value stocks as well as bonds held up like champs. Every down period is different, so be sure to diversify between stocks and bonds, between foreign and domestic and among sectors. The key is to have meaningful exposure to a lot of areas and to build up your core.

MISTAKE 6: Failing to write down your reasons for buying and selling Once you’ve got your plan, spell out why you own each investment and what would lead you to sell. For example, you could say that you own a focused equity fund as a longterm 20-year investment for its manager and its moderate costs. You’d sell if the manager left, costs were raised or asset bloat forced a change in strategy. If you have doubts about the fund in the future, you can turn to that document when you may well have forgotten what the draw was in the first place.

MISTAKE 11: Not saving enough I’d encourage you to preach the benefits of early saving to relatives and friends in their 20s or 30s. If they make regular contributions to their 401(k) and IRA accounts, reaching their goals will be quite manageable. If they don’t, they better make a killing or they’ll be behind the eight ball.

MISTAKE 7: Ignoring costs Expense ratios matter across the board. Most of the best managers work for low-cost funds. So, don’t listen to the siren song of a high-cost mutual fund or hedge fund. Results won’t live up to expectations. Expense ratios are the best predictor of future performance.

MISTAKE 13: Failing to factor taxes into portfolio decisions Like expenses, taxes play a huge role in your long-term success, but they’re no fun. So a lot of people ignore them with the hope that their funds will make such big returns that taxes won’t matter. There’s a better way to think about it. Simply putting less-efficient investments in tax-sheltered accounts and more-efficient ones in taxable accounts will pay off in a big way. In addition, when you’re shopping for a new fund for a taxable account be sure to look for those that should be efficient, such as tax-managed funds, index funds, low-turnover actively managed funds and, of course, municipal-bond funds.

MISTAKE 8: Making things needlessly complex Wall Street works overtime to sell the message that investing is complicated, messy stuff that you couldn’t possibly undertake on your own. Is it any wonder that so many investors are paralyzed with fear and indecision? There are a handful of investors who have delivered tremendous returns by using swashbuckling investment strategies and zooming in and out of arcane investments. For the rest of us mortals, though, buying and holding a portfolio composed of plain vanilla stocks and bonds — with perhaps a dash of a “diversifier” such as commodities or real estate — is more than adequate to help us reach our goals.

MISTAKE 9: Not understanding the risks Narrowly focusing on recent returns can blind investors to risks. If a fund has a long track record, you can easily get

MISTAKE 12: Failing to rebalance My 401(k) plan has a tool that automatically rebalances my investments for me. When the markets really move, your portfolio can go off-kilter and mess up your nicely laid plan. Rebalance yearly so that you’ll be buying low and selling high.

MISTAKE 14: Not building up a sufficient money market position Morningstar managers recommend that you have six to 12 months’ worth of living expenses in a money market or other cash-type account. There’s no substitute for money market funds. This emergency stash is vital in case you lose your job or have another emergency, such as unexpected home repairs. In addition, it will make market downturns less stressful.

MISTAKE 15: Ignoring costs in money market funds When interest rates rise, many fund companies will resume charging high expenses on money market funds because investors don’t pay attention. So, go with Vanguard, Fidelity or someone else who charges low costs to manage your cash MISTAKE 16: Failing to look at the big picture across accounts Economist Roger Ibbotson, chairman and CIO of Zebra Capital Management, argues: Investors tend to view each investment and each account — 401(k), IRA, college-savings account, etc. — in isolation rather than in aggregate. Trying to make every investment a winner can throw off the overarching asset allocation. It also can lead an investor to chase hot stocks, trade excessively and sell at the wrong time. If all of an investor’s accounts and individual investments are up at the same time, he should be alarmed.

It’s a sign that he may be under-diversified and taking on too much risk.

MISTAKE 17: Misreading your own abilities People who treat gambling addicts say that it’s the big winning bet that hooks gamblers. Fund investors can be a little like that. They remember that one time they accurately called the direction of the market or picked a sector fund, and they forget all the times their calls were off.

Go back over your past investments. See what went well and figure out a solution for the areas where you didn’t do well.

MISTAKE 18: Focusing on the fund instead of the manager The fact that previous managers did well or poorly is rarely relevant unless it reflects institutional strength or weakness.

Examine the current manager’s record.

MISTAKE 19: Ignoring the fund company behind the fund You may like a fund, but if the fund company has mostly lousy investors, a record of sticking it to fundholders, or both, you may pay the price in the end. Over a long time horizon, bad things happen to good funds at bad fund companies and mediocre funds at the best fund companies are more likely to turn things around.

MISTAKE 20: Worrying about daily ups and downs Don’t get stressed watching business TV or tracking the market online. Those activities are exciting and often informative but not always helpful for long-term investors. All those ups and downs have no bearing on your long-term goals. Warren Buffett, one of the most successful investors of all time, advocates buying stocks you feel so strongly about that you wouldn’t care if the stock market took a two-year holiday.

The same goes for funds. Buy them and tune out the noise.

Russel Kinnel is director of manager research for Morningstar and editor of Morningstar FundInvestor, a monthly newsletter.

smart change

6

MARCH 2019

INVESTMENTS

Dive in to foreign stocks

BY CHRISTINE BENZ

I

mported goods are so ubiquitous in our lives that we hardly give them a second thought. As I sit in my home office, I’m clacking away on my laptop from a U.S. company and talking on a cell phone from a U.S. maker. But I’m not far from a Korean-made TV and there can be little doubt that the plate I ate my lunch on was made in China.

Just as most imported goods are no longer remotely exotic, investors are becoming increasingly comfortable with foreign stocks in their portfolios, too. To make good decisions about your foreign-stock holdings, it’s important to give some consideration to the amount of initial research and ongoing oversight you’re willing to dedicate to your portfolio, how much volatility you’re willing to tolerate and whether you want to shoot for market-beating performance or are comfortable holding an index basket of foreign stocks (and the low costs that come along with such a strategy).

Thinking through your choices can help you arrive at the right answer.

WILL YOU INVEST IN INDIVIDUAL STOCKS OR FUNDS? As with investing in U.S. stocks, your first decision when investing in foreign stocks is whether you will invest in individual stocks or in some type of managed product — a mutual fund, index fund or exchange-traded fund. And as with U.S. investing, it’s perfectly reasonable to do both: invest directly in individual foreign stocks — especially blue chips such as American depositary receipts (ADRs), where trading costs are apt to be low and disclosure high — while employing funds to obtain exposure to less liquid parts of the international stock market. Here are the pros and cons of each tack.

Individual stocks

Why: Investors in individual stocks have the opportunity to generate strong, even market-beating returns by concentrating their investments in a well-researched basket of individual stocks. Individual-stock investors also can avoid the management fees that accompany mutual funds and ETFs. But if they venture beyond American depositary receipts, which allow them to buy stakes in foreign companies trading on a U.S exchange, their transaction costs are apt to be higher than what they would pay for U.S. blue chips. Bid-ask spreads also may be large when purchasing securities on foreign exchanges, further increasing trading costs. Of course, such costs also are borne by funds, and in fact, foreign-stock fund expenses generally are higher than is the case with U.S. stock funds. But as larger entities, funds may be more readily able to benefit from economies of scale than individual-stock investors can.

Why not: Investors in individual stocks may have more concentrated portfolios than what they would be able to obtain through a fund, and therefore, their portfolios’ volatility could be higher.

If they venture beyond blue-chip multinationals, whose shares are listed on U.S. exchanges, individual-stock investors may find it difficult to thoroughly research prospective holdings: Different countries take varying approaches to shareholder disclosures. Costs also may be higher.

If you go this route for all or part of your foreign-stock exposure: Morningstar’s philosophy for investing in stocks transcends geography. As with investing in the U.S. market, we believe that foreign-stock investors improve their chances of success if they focus on high-quality companies with sustainable competitive advantages, or moats, and aim to pay a reasonable price for them.

Investors can use the screening tools on Morningstar.com to identify companies that fit the bill.

Funds

Why: Whereas the investor in individual foreign stocks may have a difficult time researching and building a portfolio that’s well diversified by geography, company size, style and sector, an investor in a well-diversified fund gets instant diversification. The fund investor also can rely on professional managers to do the heavy lifting on researching companies and navigating varying disclosure regimes.

Why not: Professional management entails costs, and foreign-stock funds typically charge even more for their services than U.S. stock funds do. That can cut into the returns investors earn on their foreign-stock holdings. Funds also can foist unwanted capital gains on their shareholders, whereas individual-stock investors exert a higher level of control over capital gains realization. The taxes that foreign companies levy on their dividends also can end up denting some investors’ returns, even though investors receive a tax credit for them.

If you go this route for all or part of your foreign-stock exposure: Start with Morningstar Medalist funds to winnow down the universe to a more manageable group; our analysts believe these funds will outperform their peers in the future. You’ll find them on Morningstar Morningstar.com.

QUESTIONS TO ASK WHEN

INVESTING IN U.S. EQUITIES

F

inding the right stocks, mutual funds and exchange-traded funds requires some introspection. How much ongoing oversight are you willing to provide for your holdings? Do you get rattled when the market goes down?

Are you compelled by data showing that the typical fund manager doesn’t beat the market, or do you believe that a well-chosen basket of individual stocks or actively managed funds has the potential to earn market-beating returns? Answering those questions can go a long way toward helping you identify investments that you can live with for many years.

If you’re aiming to fill out the U.S. stock portion of your portfolio, carefully consider the following choices:

CHOICE 1: Will you invest in individual stocks or funds?

As an investor in U.S. stocks, your first decision is whether you’ll buy individual stocks or some type of a managed product — a mutual fund, index fund or exchange-traded fund — that invests in U.S. stocks. Note that many investors successfully do both. It’s not uncommon for individuals to invest the bulk of their portfolios in funds while reserving a smaller portfolio for investing in individual equities. Here are the pros and cons of investing in individual stocks and mutual funds.

Individual stocks

Why: The ability to generate strong, even market-beating returns is the key reason to consider investing in individual stocks. By concentrating your investments in companies that you’ve researched thoroughly and determined to have strong fundamentals, you have the opportunity to out-earn the return you’d earn in a mutual fund with a more diffuse portfolio. Individual stock investors also can avoid the management fees that accompany mutual funds and ETFs and exert greater control over their tax costs.

Why not: Because their portfolios are apt to be less diversified, individual-stock investors may have to deal with higher volatility than mutual fund investors. Selecting and monitoring individual stocks also requires more initial research and ongoing oversight than buying and holding mutual funds.

And while investors in individual equities can avoid fund-management fees, they will have to pay transaction costs to buy and sell, which can cut into their returns.

If you go this route for all or part of your U.S. stock exposure: Morningstar believes that stock investors greatly improve their chances of success if they focus on two key tasks: finding high-quality businesses with sustainable competitive advantages, or “moats,” and paying a reasonable (or better yet, low) price for them.

Mutual funds

Why: Buying a diversified U.S. equity mutual fund gives you instant exposure to a broad cross-section of companies. You’ll also gain access to professional management and analysts: Even if you opt for an index fund, the

mechanics of managing the fund will be overseen by a professional manager and traders. Outsourcing the management and trading of individual stocks frees you up for other tasks, such as setting and monitoring your portfolio’s overall asset allocation. As an owner of a fund, you’ll also be able to obtain institutional-level (read: lower) trading costs.

Why not: Professional management isn’t free. You’ll pay for the fund-management personnel — its managers, analysts and traders — and you’ll also pay your share of operating costs to cover everything from the fund’s website to shareholder reports. It also is worth noting that professional management doesn’t guarantee better results than what you might be able to achieve with your own hand-selected basket of individual stocks. A fund’s portfolio performance also may be affected by investor dollars flowing into and out of the fund; for example, a big influx of assets could cause the fund to have more cash than usual, or sizable redemptions could force the manager to sell shares he or she would rather hang onto. Mutual funds, especially actively managed ones, also may foist unwanted

MORNINGSTAR PICKS: DOMESTIC EQUITY FUNDS By focusing on large-company stocks, these funds are great cornerstones for an equity portfolio.

Find more at Morningstar.com.

AMG Yacktman Service (YACKX): Managers Stephen Yacktman and Jason Subotky look for high-quality companies. They tend to hold stocks for a long time, resulting in low turnover, and maintain heavy positions in individual stocks and sectors.

Dodge & Cox Stock (DODGX): Management seeks a decisive value approach, focusing on large companies that look cheap on a range of valuation measures. They hold on through tough times, which means those who invest in this fund must be patient: some out-of-favor names can remain that way for a while.

Fidelity 500 Index (FUSVX): Rock-bottom costs and a great record of closely tracking its index make this fund a top choice for exposure to the S&P 500 index.

Fidelity Spartan Total Market Index (FSTVX): This low-cost index fund offers comprehensive coverage of the U.S stock market. This fund covers nearly the entire U.S. stock market, holding around 3,500 stocks.

Harbor Capital Appreciation (HACAX): Manager Sig Segalas and his team at Jennison favor growth stocks; specifically, they look for fundamentally sound companies with long-term competitive advantages that are growing faster than the S&P 500.

Oakmark (OAKMX): Manager Bill Nygren focuses on companies with strong fundamentals – including financial health, business-growth potential, and management’s talent for capital allocation – whose prices appear attractive in absolute, not relative, terms.

capital gains distributions on their shareholders, a problem that you can avoid by buying and holding individual stocks. (Equity investors can, however, reduce the problem of unwanted capital gains distributions by buying broad-market index funds and especially exchange-traded funds.)

If you go this route for all or part of your U.S. exposure: Start with Morningstar Medalist funds to winnow down the universe to a more manageable group; our analysts believe these funds will outperform their peers in the future.

CHOICE 2: Will you buy an index fund or go with an actively managed fund?

If you’ve decided to invest in a mutual fund for your U.S. stock exposure, your next decision is whether to buy an index fund that tracks a benchmark — rather than attempting to beat it — or a fund whose manager picks individual stocks in an effort to beat the benchmark. As with the decision about whether to buy individual stocks or a fund, the decision about whether to go with an active or index fund isn’t black and white; it’s possible to hold both. Here are the pros and cons associated with each strategy.

Index funds

Why: Index funds — sometimes called passively managed funds, in contrast to those run by active managers — give you broad exposure to a given market segment, often at very low cost. Index funds come in two main subtypes: traditional index mutual funds and exchange-traded funds. Exchange-traded funds (ETFs) are similar to traditional mutual funds except that investors can trade them throughout the day, just as they can with individual stocks.

Thanks to their cost advantage relative to actively managed funds, as well as the fact that their trading costs are very low, broad-market index funds generally have beaten the typical active fund over long periods of time. With a passively managed fund, you don’t have to worry much about management or strategy changes, because what you hold is dictated by what’s in the index. Broad-market equity index funds also tend to have good tax efficiency, meaning that they make few capital gains distributions on a year-to-year basis.

Why not: You’ll never beat the market or mitigate overall market losses with index funds. You’ll simply capture market returns (or losses) minus the fund’s fees.

Because index funds always will stay fully invested and allow their winners to appreciate, they frequently perform well when the market is going up. On the flip side, because index funds are required to stay fully invested and mirror the index’s holdings at all times, their managers won’t have the opportunity to raise cash or retreat from overvalued securities if they think the market is pricey.

In practice, broad-market index funds make few changes to their portfolios, and when they do, it’s usually around the margins. But index funds focused on a specific slice of the market, such as smallcap or value stocks, Morningstar may make changes.

smart change

MARCH 2019

7

INVESTMENTS

FIND THE RIGHT

STOCK / BOND MIX

A

BY CHRISTINE BENZ

re you a stock or a bond?

You may not be accustomed to comparing yourself to a financial security, but it may be useful when you’re trying to figure out your portfolio’s optimal stock/bond mix.

The thinking goes like this: If your own earnings power, which investment researchers calls “human capital,” is very stable and predictable, then you’re like a bond. Think of a tenured college professor, whose income is secure for the rest of his life, or a senior who’s drawing upon a pension from a financially stable company. Because such an individual has a predictable income, he could keep a larger share of his portfolio in stocks than someone with less stable human capital.

He’s a bond.

At the opposite end of the spectrum would be an investment broker whose income depends completely upon the stock market. When the market is going up and the broker’s clients are clamoring to invest, her commissions are high and she also may earn a bonus. But when the market is down, so is her income, and her bonus may be nonexistent. She’s a stock.

She’d want to hold much more in bonds than stocks, because her earnings are so dependent on the stock market.

Just as our career paths affect how we view our own human capital, so do our ages. When you’re young and in the accumulation phase, you’re long on human capital and short on financial capital, meaning that you have many working years ahead of you but you haven’t yet amassed much in financial assets. Because you can expect a steady income stream from work, you can afford to take more risk by holding equities. As you approach retirement, however, you need to find ways to supplant the income that you earned while working. As a result, you’ll want to shift your financial assets away from equities and into income-producing assets such as bonds, dividend-paying stocks and income annuities.

Of course, there are no guarantees that stocks will return more than bonds, even though they have done so during very long periods of time. Over shorter time periods, stocks certainly can suffer, and

MORNINGSTAR LIFETIME ALLOCATION INDEXES: ASSET MIXES

Use these indexes to help guide your portfolio’s asset allocation. Find the year closest to when you expect to retire and look for the allocation that aligns with your risk capacity.

Target Retirement Year

2060 2055

2050 2045 2040 2035 2030 2025 2020

Aggressive Allocations Stock %

94

94

94

94

94

91

84

75

66

Bond %

3

3

3

3

3

5

11

18

23

Inflation Hedge %

3

3

3

3

3

3

4

7

10

Cash %

0

0

0

0

0

0

0

1

2

Moderate Allocations Stock %

90

90

90

89

85

78

68

57

49

Bond %

7

7

7

8

11

17

25

32

35

Inflation Hedge %

3

3

3

3

3

4

7

10

13

Cash %

0

0

0

0

0

1

1

2

3

later date is impossible to pull off with any degree of accuracy, so much so that most professional investors don’t try it.

Maintaining a fairly stable asset allocation has a couple of other big benefits: It keeps your portfolio diversified, thereby reducing its ups and downs, and it also keeps you from getting whipped around by the market’s day-to-day gyrations. An asset-allocation plan provides your portfolio with its own true north. If your portfolio’s allocations veer meaningfully from your targets, then and only then should you make big changes.

To find the right stock / bond mix, you’ll need: ! a list of your current investments ! an estimate of the year in which you plan to retire. ! Morningstar.com’s Instant X-Ray tool, which can be found at morningstar. com/portfolio.html.

STEP 1

Conservative Allocations Stock %

83

82

81

77

68

57

46

38

32

Bond %

15

16

17

21

28

36

43

47

48

Inflation Hedge %

2

2

2

2

4

6

9

13

17

Cash %

0

0

0

0

0

1

2

2

3

Inflation hedges include inflation-protected bonds and commodities. June 2017

over periods as long as 10 years, stocks can trail bonds. For instance, from February 2002 to February 2012, U.S. stocks gained less than 5.0 percent per year on average, whereas high-quality U.S. bonds gained an average of 5.5 percent per year and endured much less volatility. Against a backdrop like that, it might be tempting to ignore stocks altogether.

At the same time, however, it stands to reason that during very long periods of time, various asset classes will generate returns that compensate investors for their risks. Because investors in stocks shoulder more risk than bondholders and bondholders take on more risk than investors in ultra-safe investments such as certificates of deposit, you reasonably can expect stocks to beat bonds and bonds to beat CDs and other “cash”type investments during very long periods of time. In turn, that suggests that younger investors with long time frames

should have the majority of their investments in stocks, whereas those who are close to needing their money should have the bulk of their assets in safer investments such as bonds and CDs. During a 10-year period prior to December 2017, stocks, bonds and cash have settled into a more familiar pattern, with stocks outpacing bonds by 4.5 percentage points on an annualized basis, and both stocks and bonds leaving cash in the dust.

What I’ve discussed so far is called strategic asset allocation — meaning that you arrive at a sensible stock/bond/cash mix and then gradually shift more of your portfolio into bonds and cash as you get older. Of course, it would be ideal if we all could position our portfolios to capture stocks’ returns when they’re going up and then move into safe investments right before stocks go down. In reality, however, timing the market by, say, selling stocks today and then buying them back at a

Before determining a target asset allocation, start by checking out where you are now. Log on to Morningstar’s Instant X-Ray tool. Enter each of your holdings, as well as the amount that you hold in each. (Don’t include any assets you have earmarked for short-term needs, such as your emergency fund.) Then click Show Instant X-Ray. You’ll be able to see your allocations to stocks (both domestic and international), bonds, cash, and “other” (usually securities such as convertibles and preferred stock), as well as your sector and investment-style positioning.

STEP 2

The next step is to get some guidance on where you should be. Use the asset allocation in the table on this page that corresponds to your anticipated retirement date. Remember, this allocation corresponds to your long-term goals (for example, retirement assets), not your emergency fund or any shorter-term savings that you’ve earmarked for purchases that are close at hand.

Excerpted with permission of the publisher, Wiley, from “30-Minute Money Solutions: A Step-by-Step Guide to Managing Your Finances” by Christine Benz. Copyright 2010

by Morningstar.

A KEY QUESTION TO ASK WHEN INVESTING IN BONDS

Y

ou’ve used asset-allocation calculators and compared your portfolio to target-date funds geared toward your retirement date. You even may have checked in with a financial adviser for a temperature check. And all systems point in the same direction: It’s time to add some bonds.

Check that, it’s way past time to add some bonds.

But if you’re like many investors, even seasoned ones who have long been navigating the stock market, you may be balking. Even if you’re willing to swallow your misgivings about bonds’ meager yields and the risk that rising rates could crunch bond prices, you may be dogged by a more basic issue: Where to start?

The first decision bond investors must make is the delivery system: individual bonds or a bond fund? For most

investors, especially those starting out, the simplicity, diversification and professional management that come along with investing in a bond fund can be difficult to beat. But individual bonds may be appropriate in some instances. Here are the pros and cons of each strategy.

Individual bonds

Why: The key benefit of buying individual bonds is that you can readily match the bond’s maturity to your time horizon. Assuming you’ve bought a bond from a high-quality issuer, you’ll receive your coupon payments and get your principal back when the bond matures, even though interest rates may have moved up, down and sideways over your holding period.

Why not: While the marketplace for individual-bond buyers has improved

over the past decade, it still can be tricky to research individual bonds’ fundamentals and determine whether the price you’re paying is a fair one. This is especially true once you venture beyond government-issued and high-quality corporate bonds. Trading costs also can eat into the returns that small investors earn on individual bonds.

If you go this route for all or part of your bond exposure: Focus on very high-quality, highly liquid bonds and make sure you fully understand all of the costs and risks that come along with making the investment.

Bond funds

Why: Fund investors, even small ones, get diversification and professional management in a single shot by investing in a bond fund. And while a bond

fund may incur short-term losses when interest rates rise, the bond-fund manager will then be able to swap into new, higher-yielding bonds as they become available, thereby offsetting the hit to principal.

Why not: The fees you pay for fund management may cut into your return.

And there’s no guarantee you’ll be able to take exactly as much out of your bond fund as you put in.

If you go this route for all or part of your bond exposure: Be sure to start building your bond-fund portfolio with core, intermediate-term funds that give you a lot of diversification in a single holding. Be careful with funds that focus on a narrow part of the market or have high costs, as high expenses correlate neatly with risk-taking Morningstar among bond funds.

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8

MARCH 2019

EARLY PLANNERS

COMMENTARY

by Christine Benz

Fresh start to retiring Staging your future can get you on the right track

H

ave you ever stopped to think about all of the different tasks your brain is processing when you drive a car?

Figuring out how to pilot the vehicle from point A to point B is the overarching job, but you’re also completing scores of little tasks in very short bursts of time — merging into traffic, minding the street signs and speed limit and watching out for pedestrians and bicyclists, to name just a few. Is it any wonder it’s illegal to text and drive at the same time?

Though we may not give it much thought, most of us are multitasking throughout our financial lives, too.

Even though retirement may be your long-range goal, it’s a good bet you’re knocking off scores of smaller financial jobs along the way — paying off student loans and home mortgages and socking away funds for college for the kids, to name some of the biggies. You also are practicing the equivalent of defensive driving — building an emergency fund to defray the periodic large car repair or vet bill, for example, and purchasing various insurance products.

We designed this guide to address the fact that financial multitasking is a way of life for people at all life stages, and to help you do it even better.

Because the financial priorities and jobs of a new college grad are vastly different from a 62-year-old who’s trying to figure out if he’s on track to retirement, we’ve organized the information in the next pages by life stage.

We’ve crafted sections for early-career accumulators (20- and 30-somethings), mid-career accumulators (40- and 50-year-olds), pre-retirees, and retirees. For each age band, we highlighted the most important financial “jobs” to have on your radar — along with advice about how to get them done.

Because Morningstar is first and foremost an investment-research firm, the guide includes plenty of concrete guidance on making smart investment decisions. In addition to discussing which investment types are appropriate at each life stage, we’ve also provided model portfolios to depict how all the pieces come together and showcase sensible security-selection techniques. In keeping with Morningstar’s long-standing emphasis on the virtues limiting investment costs and spreading your money across investments with disparate characteristics, the portfolios are anchored by broadly diversified low-cost mutual funds and exchange-traded funds.

The guide also includes deep dive articles that tackle some of the most nettlesome tasks that can arise at various life stages. For those starting out in their investing careers, for example, we’ve taken a closer look at topics such as right-sizing an emergency fund (next page) and avoiding the big traps when saving inside of a 401(k) plan (pages 20-21). For more seasoned investors, the guide features articles about tax matters (pages 22-23) and in-retirement portfolio withdrawals (page 13), among other topics.

No matter your life stage, we’re confident that you’ll be able to pull a few tips — or maybe even more — to help you get where you need to go, avoid the big roadblocks, and enjoy the trip. And isn’t that what it’s all about?

Many happy returns!

Christine Benz is director of Personal Finance at Morningstar Inc. She is the author of “30-Minute Money Solutions: A Step-by-Step Guide to Managing Your Finances.” In addition, Benz is co-author of “Morningstar Guide to Mutual Funds: 5-Star Strategies for Success,” a national bestseller published in 2003, and author of the book’s second edition, which was published in 2005. Before assuming her current role in 2008, Benz served as Morningstar’s director of mutual fund analysis. She has worked as an analyst and editor at Morningstar since 1993.

Investing

GOALS FOR SHORT AND INTERMEDIATETERM

J

BY CHRISTINE BENZ

ust as putting and chipping look deceptively simple to beginning golfers, so can the process of investing for short-term investors. It looks so easy, but it can be difficult to get right.

For example, investors may confuse their risk capacity with risk tolerance, thereby venturing out on the risk spectrum and incurring losses just before they need to tap their portfolios. Or they might assume that just because stocks have delivered returns that have bested other asset classes’ in the past five years, they’ll do it again during the next five.

At the opposite, conservative extreme, investors might assume that the best way to meet short- and intermediate-term goals is to stick exclusively with guaranteed products such as CDs or money market accounts.

That’s not an unreasonable idea given how small the current differential is between cash and products that do not promise stability of principal; for very near-term expenditures, cash is best. But if the investor’s time horizon is longer than a couple of years, the bite of inflation means that guaranteed products will be a losing proposition.

Running the numbers

Investing for short- and intermediate-term goals is, in many ways, a game of probabilities. While the S&P

B

500 posted a positive return in 86 percent of rolling 10-year periods in the past 25 years, stocks have been much less of a sure thing for shorter time horizons. Over rolling one- and three-year periods from Feb. 1, 1993, through Jan. 31, 2018, the S&P has posted a loss roughly 19 percent and 22 percent of the time, respectively, and some of those short-term losses were punishing, especially in one-year windows. Meanwhile, bonds have a much higher probability of holding their ground over shorter time periods. During the same 25-year period, which was admittedly strong for bonds, the Bloomberg Barclays U.S. Aggregate Bond Index had a positive return in every rolling three-year time period and in 91 percent of rolling 12-month periods. Of course, past is not prologue. In a sustained period of rising interest rates, bond losses could be higher and more frequent than they have been in the recent past.

What’s a well-meaning short- or intermediateterm investor to do?

Well, even if bond returns aren’t a sure thing to make money going forward, that doesn’t automatically make stocks the better bet for short- or even intermediate-term time horizons. Historical returns suggest that if your time horizon is less than 10 years, stocks’ returns have been too unreliable for them to

be a worthy receptacle for the whole of your money. Stocks might be a component of a portfolio if the time horizon is close to 10 years, but they shouldn’t be the whole kitty. Investors have even more reason to check their near-term expectations for stocks as they’ve been on an extended tear for several years and that valuations, while not at skyscraper levels, aren’t especially low right now.

The answer is that if you’re saving for a goal that’s close at hand, whether a home down payment, remodeling or a special family trip in five years, you need to take some risk but not too much. You also need to recognize the role your savings rate plays in all of this: If returns from reasonably safe asset classes are apt to be muted during your holding period — and current bond yields suggest they will be — you may need to step up your savings rate to achieve your goal rather than relying on portfolio returns to do the heavy lifting.

The portfolios on the next page are geared toward investors who expect to need their money within 5-10 years. Investors with very short time horizons of just a few years should stick with cash. Because many investors save for short- and intermediate-term goals outside of their retirement accounts, I’ve created portfolios for both taxable and tax-deferred Morningstar accounts.

EARLY PLANNERS: Road Map

ecause they’re just starting out, early career accumulators — loosely defined as people in their 20s and 30s — don’t typically have much in the way of financial capital (unless they’re technology savants or supermodels, that is). Not only are their earnings often low relative to where they’ll be in the future, but new college grads also may be digesting college debt.

But early career accumulators have other assets that their older counterparts can look upon with envy. With a whole lifetime of earnings stretching before them, early career people are long on what investment researchers call human capital: Their ability to earn a living is their greatest asset by a mile.

Investors in their 20s and 30s have a valuable asset when it comes to investing, too: With a very long time horizon until they’ll need to begin withdrawing their money (for retirement, at least), early career investors can better harness the power of compound interest. They also can tolerate higher volatility investments that,

over long periods of time, are apt to generate higher returns than safer investments.

If you’re just embarking on your investment journey, it’s hard to go too far wrong with the mantra of investing as much as you can on a regular basis and sticking with very basic, well-diversified investments.

But it also pays to think of your “investments” in a broad sense, steering your hard-earned dollars to those opportunities that promise the highest return on your investment over your time horizon.

For most people, that will require a bit of multitasking: Rather than wait until all of your student loans are paid off to begin investing in the market or saving for a down payment for a home, for example, you may want to earmark a portion of each paycheck for all three “investments.”

Here are some tips for investing well and yes, multitasking, in your 20s and 30s.

Put debt in its place

One of the earliest forks in the road

that many early accumulators face once they begin earning a paycheck is whether to steer a portion of that paycheck to service debt or to invest in the market. If it’s high interest-rate credit card or student loan debt that features a particularly high rate, it’s worthwhile to earmark the bulk of one’s extra cash for those “investments.” The reason is that it’s impossible to earn a high guaranteed return from any portfolio investment today, whereas retiring debt delivers a guaranteed payoff that’s equal to your interest rate. As a general rule of thumb, investors carrying debt with an interest rate of 5 percent or more would do well to focus on paying down those loans (or possibly refinancing into more favorable terms) before moving full steam into investing in the market. One exception: building an emergency fund (more on this at right).

Make the investment in human capital

While we’re on the topic of “investments” in the broadest sense, the 20s and 30s also are the ideal life stage to

smart change

MARCH 2019

9

EARLY PLANNERS

4 steps to setting up an

A short-term portfolio for taxable accounts

Spending Horizon: 5 Years or Less 20-40 percent Cash 40-60 percent Fidelity Limited Term Municipal Income (FSTFX) 20 percent Fidelity Intermediate Municipal Income (FLTMX)

This portfolio is geared toward taxable investors (that is, those investing outside of a retirement account) with time horizons of roughly five years. Thus, it’s anchored in cash (certificates of deposit, money market accounts and so forth) and a short-term bond

fund. It also features an intermediate-term fund to help boost its yield. Morningstar analysts have long been impressed by Fidelity’s careful and deliberate approach to the muni markets, and the funds that dominate this portfolio showcase what the firm does well.

A short-term portfolio for tax-deferred accounts Spending Horizon: 5 Years or Less 20-40 percent Cash 40-60 percent Fidelity Short-Term Bond (FSHBX) 20 percent: Dodge & Cox Income (DODIX)

This portfolio is geared toward investors with time horizons of roughly five years; it mirrors the structure of the taxable portfolio above but doesn’t pay attention to tax efficiency. CDs, money market funds and money market accounts make up as much as 40 percent of the portfolio, with a high-quality

short-term bond fund composing another 40 percent. A smaller portion goes into an intermediate-term bond fund to boost the portfolio’s yield. Here, I’ve used Dodge & Cox Income, whose managers’ threeto five-year time horizon for their holdings syncs up with the five-year time horizon of the portfolio.

An intermediate-term portfolio for taxable accounts

Spending Horizon: 5-10 Years 20 percent Cash 20 percent Fidelity Limited Term Municipal Income (FSTFX) 40 percent Fidelity Intermediate Municipal Income (FLTMX) 20 percent Vanguard Total Stock Market Index (VTSMX)

Geared toward a taxable investor with a spending time horizon between five and 10 years, this portfolio includes cash and the same municipal-bond funds that appear in the portfolio above, albeit in slightly different allocations. It also includes a slice of

tax-efficient equity exposure. I’ve used a broad market traditional index fund, but investors could reasonably use a large-cap exchange-traded fund or a tax-managed equity fund such as Vanguard Tax-Managed Capital Appreciation (VTCLX).

An intermediate-term portfolio for tax-deferred accounts Spending Horizon: 5-10 Years 20 percent Cash 20 percent Fidelity Short-Term Bond (FSHBX) 40 percent Dodge & Cox Income (DODIX) 20 percent Vanguard Dividend Appreciation (VDADX)

This portfolio, geared toward investors in lower tax brackets or those investing in tax-deferred accounts, is stair-stepped by risk level, from cash to short-term bonds to intermediate-term bonds to stocks. I’ve mirrored the allo-

make investments in your own human capital — obtaining additional education or training to improve your earnings power over your lifetime.

Of course, not every such investment pays off, and it’s ideal if you can get your employer to shoulder at least some of the financing. But if you have considered an advanced degree or extra training of any kind, the earlier you get started, the higher your lifetime return on your outlay is apt to be.

Kick-start your retirement accounts

There are a lot of reasons that early accumulators put off saving for retirement. There’s the not small fact that many people in their 20s and 30s are saddled with heavy student debt loads. Moreover, 20- and 30-somethings often have one or more shorter term goals competing for their hardearned dollars alongside retirement savings: down payments for first homes, cars, weddings and children, for example.

cations of the taxable intermediate-term portfolio above but have not factored tax efficiency into the investment selections. Vanguard Dividend Appreciation has historically had smaller bear-market losses than other core equity funds.

Psychology also is in the mix: With retirement three or four decades into the future, people who are just embarking on their working careers in their 20s and 30s may be hard-pressed to feel a sense of urgency in saving for it.

Yet the youngest investors have the longest time to benefit from compounding, and that benefit accrues even if they’re only able to save fairly small sums and the market gods serve up “meh” returns over their time horizons.

The 22-year-old who starts saving $200 a month and earns a 5 percent return per year will have more than $362,000 at age 65. Meanwhile, an investor who waits until 35 to start investing yet socks away $300 a month and earns a 6 percent return will have a little more than $300,000 at age 65.

Those first 10 years of missed compounding swamp both higher returns and higher contributions later on, underscoring the virtue of getting started on retirement saving as soon as you can, even if it Morningstar means starting small.

EMERGENCY

FUND A

BY CHRISTINE BENZ

few years ago, I met a lovely couple in their mid20s who were struggling with more than $100,000 in student loan debt.

Though their salaries covered their regular payments and expenses (such as mortgage, utility bills, etc.), there was no room for error. As a result, they began charging unexpected expenses like car repairs and veterinary care on their credit cards, incurring exorbitant interest fees along the way.

They clearly were troubled about having dug themselves into such a deep hole, and they were eager to do everything that they could to pay off both types of debt as soon as possible. We discussed various ideas for reducing their financing costs.

What I think surprised them, though, was that I didn’t suggest that they put every extra penny toward paying down their debt. Rather, I urged them to simultaneously set up an emergency savings fund.

True, setting up an emergency fund would probably mean that it would take them longer to pay off all of their debt, but it also would guard against the prospect of taking on any more debt than they already had. Not only could they use their emergency fund to pay unexpected bills, but it also would provide a needed cushion should one of them lose their job.

In fact, creating a safety net in case of job loss is the key reason to set up an emergency fund. Conventional financial planning wisdom holds that you should have three to six months’ worth of household living expenses tucked away in your emergency fund, with the thought being that it would take you that long to find a new job if you should lose yours. However, I would recommend building yourself an even more generous cushion if you can swing it, preferably nine months’ to a year’s worth of living expenses. That’s particularly true if you’re highly paid or work in a highly specialized field, because it’s usually more difficult to replace such jobs. And of course, if you have any reason to believe that your job is in jeopardy — either because of problems in the economy at large or at your own company — you also should aim to build a larger emergency fund.

In addition to determining the right amount for your emergency fund, you also have to take care in selecting the investments that you put inside it. As a general rule of thumb, your emergency fund should consist of investments with maturities of less than one year, including checking and savings accounts, money market accounts and CDs. This is money that you could need to tap in a pinch, so you want to steer clear of higher-yielding investments that could be tough to sell or that you might have to sell at a loss if you needed to get out in a hurry. Instead, you need to stick with vehicles that ensure you’ll be able to take out as much as you put in.

Here’s an overview of the types of savings and investment vehicles that are acceptable for your emergency fund: Online savings accounts: These vehicles often offer the most attractive yields for cash. They also typically offer at least a few transactions per month.

Deposits of up to $250,000 per institution will be covered by FDIC insurance.

Checking and savings accounts: Convenience is the big plus here, but rates may be rock-bottom. Deposits of up to $250,000 per institution will be covered by FDIC insurance.

Money market deposit accounts:

These interest-bearing savings accounts typically offer a limited number of transactions per month, and deposits of as much as $250,000 per institution are FDIC-insured.

Certificates of deposit: CDs are apt to have a higher yield than checking, savings, or money market accounts. They also carry FDIC insurance for deposits of as much as $250,000 per institution.

The big drawback to holding CDs in your emergency fund, however, is that you’ll pay a penalty to withdraw money from a CD prematurely. So if you hold CDs as part of your emergency fund, you’ll have to weigh the higher yield against the risk of having to pay a penalty to pull money out.

Money market funds: A money market mutual fund can be a good option for an emergency fund, and yields may be higher than what you’d earn on your checking, savings, or money market account. Because money funds buy very short-term bonds, they can readily swap into newer, higher-yielding securities when interest rates edge up. The big downside relative to the checking and savings accounts, CDs, and money market accounts is that money market fund assets are not FDIC-insured.

Here are the key steps to take when setting up your emergency fund.

Step 1: Determine your monthly living expenses. Don’t include nonessential items that you could live without in a pinch, such as a dog walker and discretionary clothing purchases. Multiply that number by three months. This is your absolute minimum savings target for your emergency fund.

Step 2: Add up the aggregate investments that you hold in your checking and savings accounts, money market accounts and funds, and CDs. Exclude any assets that you have earmarked for other purposes, such as money that you’re saving for a car down payment or college tuition; also exclude any cash holdings in your stock or bond mutual funds. This is your current emergency fund.

Step 3: Subtract the figure from Step 2 (your current emergency fund) from the figure in Step 1 (your target emergency fund). This is how much you need to save at a bare minimum—it should be double this level or more. Setting money aside to hit this savings target should be your main savings priority in the months ahead. (If you’re also paying off high-interest credit card debt, you should try to build up your emergency fund at the same time.)

Step 4: To home in on the best investments for your emergency fund, start by looking at the yields for your current investments. Then go to www.bankrate.com to find current yields for CDs, money market deposit accounts, and money market mutual funds; compare them with what you’re earning currently.

Bearing in mind the above guidelines about FDIC insurance and liquidity, also remember that it’s fine to use a combination of these vehicles rather than holding your entire emergency fund in one place.

For example, you may choose to keep two months’ worth of living expenses in your checking account and the rest of your emergency fund in a higher-yielding CD or money market fund.

A version of this article originally appeared in “30-Minute Money Solutions: A Step-by-Step Guide to Managing Your Finances.” Excerpted with permission of the publisher John Wiley & Sons, Inc. Morningstar

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MARCH 2019

MID-CAREER PLANNERS

CASE STUDY:

An exclusive portfolio for moderate savers

H

BY CHRISTINE BENZ

ow different should your portfolio look when you’re in your 40s versus how it was positioned when you were just starting out?

Not all that different, it turns out.

The portfolios here are for a slightly older investor, one who intends to retire near 2035. The moderate portfolios include more than 80 percent in stocks and a still-sizable allocation to foreign names.

As with other more aggressive portfolios, I’ve used Morningstar’s Lifetime Allocation Indexes to help set the baseline asset allocations. In this case, I used the Moderate version of the 2035 Index.

To populate the portfolios – one composed exclusively of mutual funds and the other focusing on ETFs — I’ve employed funds that are highly rated by our analyst team. Most of the funds earn Gold ratings, but I used Silverand Bronze-rated funds in cases where suitable Gold-rated funds were unavailable.

The Moderate Saver mutual portfolio consists of the following funds in the following allocations:

The mutual fund portfolio

15 percent: Primecap Odyssey Growth (POGRX) 15 percent: Vanguard Dividend Appreciation (VDADX) 15 percent: Oakmark Fund (OAKMX) 10 percent: Vanguard Extended Market Index (VEXAX) 21 percent: Vanguard Total International Stock Index (VTIAX) 5 percent: Oakmark International Small Cap (OAKEX) 19 percent: Metropolitan West Total Return Bond (MWTRX)

The ETF portfolio

47 percent: Vanguard Total Stock Market Index ETF (VTI) 8 percent: Vanguard Small-Cap Value ETF (VBR) 20 percent: Vanguard FTSE Developed Markets ETF (VEA) 5 percent: Vanguard FTSE Emerging Markets ETF (VWO) 20 percent iShares Core Total USD Bond Market ETF (IUSB) I stuck with the same basic basket of funds that I would have used for an early planner portfolio, and the allocations aren’t terribly different, either. Given that a person in his or her 40s has a 20-year time horizon until retirement, it’s only reasonable that the bulk of the portfolio remains in stocks, which should enhance its return potential.

That said, there are a couple of noteworthy differences between an aggressive, early-planner portfolio and these moderate portfolios.

First, the moderate portfolio’s equity allocation is a touch lower. Much of that differential owes to the moderate portfolios’ lighter international equity allocations. However, 40-somethings with high risk tolerances—that is, those who didn’t freak out and sell during the global financial crisis—could reasonably keep their all-in equity weightings as high as 90 percent.

The bond pieces of the moderate portfolios also are higher than those of a more aggressive portfolio. Note that Morningstar’s Lifetime Allocation Index for 2035 retirees with moderate time horizons contains tiny stakes in both Treasury Inflation-Protection Securities and foreign bonds. However, the allocations are so small that it’s hard to see that their effect on performance would be significant enough to make initiating new positions worthwhile.

How to use

While I expect the portfolios to perform well over time, the key goal of all of my model portfolios is to depict sound asset-allocation and portfolio-management principles. Thus, mid-career individuals can use the moderate portfolios to help assess their own portfolios’ positioning.

I developed the portfolios with open architecture in mind—that is, I assumed that an investor wouldn’t mind buying holdings from separate firms. But because all of the holdings shown here are mainstream in their exposures, investors who would like to stick with a single provider or supermarket could likely find funds with similar characteristics at their own firms. (Here again, Morningstar analysts’ Medalist funds can come in handy.)

I also developed the portfolios without consideration for tax efficiency—that is, I assumed they would be held inside of a tax-sheltered wrapper of some kind, such as an IRA. Investors who intend to hold their portfolios inside of a taxable account would want to put a greater emphasis on tax efficiency, emphasizing index funds and ETFs on the Morningstar equity side, for example.

5

MISTAKES THAT CAN BREAK

T

YOUR RETIREMENT SAVINGS PLAN

hose who are saving for retirement often worry over the things they want to get right—finding an appropriate investment mix or buying the best mutual funds.

These decisions are undoubtedly important, but just as critical to retirement success may be the things you don’t get wrong—the mistakes you avoid along the way, as you’re building your nest egg.

All too often, life gets in the way, and can put the best laid retirement plans at risk.

Morningstar.com’s editor sat down with Christine Benz, Morningstar’s director of personal finance, to discuss five common pitfalls that can trip up retirement savers.

Question: Christine, although it can be tempting when unexpected expenses come up, pitfall number one is raiding your company retirement account.

Christine Benz: Taking premature withdrawals from a company retirement plan can be very costly. You’ll have to pay ordinary income taxes on that withdrawal, and you’ll also have to pay a penalty if you’re prior to retirement age.

Q: Some plans have the option for participants to take a loan from their retirement account. Is that a better option than taking the money out directly?

Benz: It is a better option, but it’s still not perfect.

The reason it’s better is that you will have to pay that money back to yourself, and you’ll have to pay interest on the amount that you’ve withdrawn.

The key reason that it’s not a great idea, though, is that if you do lose your job prematurely, you’ll have to pay that money back almost right away; you usually have 90 days to get the money back into the account to avoid taxes and/or penalties. If you’ve lost your job, that could be very difficult to do.

Q: Early withdrawals or loans from 401(k)s often happen during times of emergency. Pitfall number two is not having an emergency account that would essentially prevent you from having to do that.

Benz: You’ll want to have some safe money set aside outside of

your company retirement plan to meet those emergency expenses as they occur. Whether it’s a leaky roof or some car repair that you’ve got to pay for, you’ll have that money set aside in your checking or savings account. It will be there in your time of need, and you won’t be forced to raid your retirement fund.

Q: This money should essentially be invested or saved in something very safe.

Benz: Very safe—money market accounts, checking accounts, CDs. It’s money that will not ever be at low ebb when you need to withdraw it.

Taking premature withdrawals from a company retirement plan can be very costly.

Q: How much should you have in an emergency account?

Benz: The standard rule of thumb is that you want to hold three to six months’ worth of living expenses in your emergency fund.

I think that’s a good starting point.

But certainly people who have more volatile earning streams, those in careers where there is a high probability of disruption in their job, or higher earners would want to have more like a year’s worth of living expenses in their emergency fund.

Q: A lot of retirement savers don’t just have retirement to save for; they have other things such as college education for their children. Pitfall number three is not prioritizing those savings correctly.

Benz: We’re all multitasking for most of our earnings years. It’s im-

portant to make sure that we have our priorities straight.

Certainly there is a strong emotional motivation to fund higher education for children, but you’ll want to step back and think about the fact that retirement is a very big-ticket item. Retirement needs to be at the top of your priority list.

Also when it comes to weighing college funding versus retirement funding, think about the levers that your child will have if he or she gets to college age and maybe you haven’t saved enough. There are loans that he or she could take.

But you won’t be able to take a loan to pay for your own retirement.

Q: Pitfall number four involves not bumping up your retirement savings contributions when you get a raise.

Benz: This is one of the most painless ways to increase your savings rate. If you do bump up your contributions along with your earnings, you will be putting money into the account without ever having seen it. So it’s a very nice and painless way to increase your savings rate.

Also, if you don’t bump up your contributions as your salary increases, your level of consumption, your standard of living, will be going up and up, and when you get to retirement you’ll expect to continue with that standard of living. However, you won’t necessarily be funding that retirement at an appropriate level if you don’t step up your contributions along the way.

Q: Most folks have the message now that retirement can be an expensive proposition. Pitfall number five is not considering some of the other retirement savings vehicles that may be available to you.

Benz: It’s hard to beat a company retirement plan for painless savings; your money automatically goes into that plan month in and month out. That’s a great way to build the bulwark for your retirement savings plan.

But it is important to think about supplementing it with a vehicle such as an IRA or even a taxable investment account. The key reason is that you are setting aside additional funds for retirement, and you may also be able to invest in investment types that aren’t available inside the confines or your 401(k) or company Morningstar retirement plan.

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MID-CAREER PLANNERS

Opting for traditional insurance may seem more appealing because of its familiarity and its lower out-of-pocket costs. But the tax benefits of HSAs are such that individuals should revisit that decision.

EXP INSIGEHRTT S

BOOST YOUR RETIREMENT FUNDS WITH

Health Savings Accounts

Y

BY CHRISTINE BENZ

ou’ve crunched the numbers and determined that in order to retire on schedule, you’ve got to kick up your retirement-plan contributions. So, you’ve dutifully been making the maximum allowable company retirement plan and IRA deposits, and you’ve even begun saving for retirement in your taxable brokerage account.

But there’s one retirement wrapper that you may be neglecting: a health savings account (HSA).

True, HSAs aren’t specifically designed as retirement savings vehicles.

Rather, their ostensible function is to cover the higher out-of-pocket costs that accompany being covered by a high-deductible health-care plan rather than a traditional health-care plan. But for people with limited ongoing medical expenses, an HSA can be a great piggy bank for additional retirement savings. And the tax benefits of HSAs are so generous that even people with more significant health-care costs might consider paying those expenses out of pocket, provided they can afford to do so, allowing the money can continue to compound in the HSA. Many workers have the option to choose a traditional health-insurance plan through their employer, such as a PPO, or the high-deductible health-care plan/HSA combination. Opting for traditional insurance may seem more appealing because of its familiarity and its lower out-of-pocket costs. But the tax benefits of HSAs, which are available only to those

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who are covered by a high-deductible health-care plan, are such that individuals should revisit that decision—especially if they’re already taking advantage of other retirement-savings options like IRAs and 401(k)s.

Alphabet soup confusion

Before discussing the merits of HSAs as a retirement-savings vehicle, let’s first clear up a few common points of confusion about the accounts. People often mix up HSAs with FSAs, or flexible spending accounts, and there are some similarities.

But there are key differences, too.

With both account types, you don’t pay taxes on the money going into the account, and the money isn’t taxable on the way out, either, provided it’s being used for qualified health-care expenditures. Both account types cover a wide range of expenses, including deductibles and copayments, but the funds are not usable for insurance premiums in most instances unless you’re over age 65.

However, the limit on FSA contributions is lower than is the case for HSAs. For 2019, the HSA contribution limit is $3,500 for individuals with self-only coverage through a high-deductible health-care plan and $7,000 for those with family coverage. People over age 55 can contribute an additional $1,000 to an HSA for 2019 (similar to an IRA catch-up contribution). Meanwhile, the contribution limit is $2,700 for FSAs, and there are no catch-up contributions for people over 55.

The major difference between HSAs and FSAs, however, is that HSA owners have much more of an opportunity for their assets to grow over time. Flexible spending

accounts are no longer strictly “use it or lose it” as they were in the past; before the IRS changed the rules in late 2013, FSA funds not used by year-end would be forfeited. But FSA-account owners can only roll over $500 of their unused balances from one year to the next.

By contrast, there’s no limit on the amount of unused HSA funds that can roll over from one year to the next.

Moreover, HSA assets can be invested in stocks and bonds, as well as interest-bearing savings accounts, whereas monies in an FSA do not compound.

Yes, you will need the money (but it’s OK if you don’t)

Some investors considering an HSA as an additional retirement-savings vehicle may be put off by the fact that there are strictures on health-care expenses. The only way to obtain the triple tax benefit that HSAs afford—pretax contributions, tax-free compounding, and tax-free withdrawals—is to use the proceeds to cover health-care costs. But being realistic about the out-of-pocket health-care costs you’re apt to face in retirement can help you get over that hurdle in a hurry.

It’s also worth noting that at age 65, HSA investors can pull out their funds and use the proceeds on anything they like. The tax treatment isn’t as favorable as it would be if the distributions were used for qualified health-care expenditures, but it’s still decent. In fact, it’s akin to the tax treatment of assets in a traditional 401(k) or deductible traditional IRA: pretax contributions, tax-deferred compounding, and withdrawals taxed as ordinary income. From that standpoint, funding an HSA is on near-equal footing

with funding a 401(k). (If you pull assets from an HSA prior to age 65 and don’t use them on qualified health-care expenses, you’ll owe both ordinary income taxes and a 20 percent penalty.)

Which account type gets top billing?

Even HSA true believers may find themselves stumped on a few items, though. Assuming they have a finite pool of assets to invest each year, which account type should you give priority: 401(k), IRA, or HSA? We posed that question to investment advisor Rob Morrison, president of Huber Financial Advisors in Lincolnshire, Illinois. He believes that as a retirement-savings vehicle, an HSA should come after a 401(k) or IRA mainly because early HSA withdrawals come with more strings attached. “HSAs should be funded only after 401(k)s and IRAs in most cases because access to [HSA] funds for retirement is allowable at 65 versus 59 for 401(k)s and IRAs. And the penalty is higher (20% versus 10% for IRAs and 401(k)s) for any non-medical distributions prior to [those ages],” he said.

Financial advisor Allan Roth of Wealth Logic in Colorado Springs, is of a similar mind, but thinks that savers might reasonably put an HSA further up in the funding queue under certain circumstances. “In practice, I use an HSA after all other tax-advantaged vehicles are maxed out, but there is an argument to use it even before. This is especially true if one has a lousy 401(k) with expensive options and no matching,” Morningstar he said.

MID-CAREER PLANNERS: Road Map

nvestment advice abounds for people just starting out in their careers, as well as for those who are getting ready to retire.

But mid-career investors, people in their 40s and 50s? Not so much. Workers at this life stage may be at their peak earnings level, and therefore may have more complex financial needs than their younger counterparts. Moreover, mid-career investors are frequently juggling the competing financial demands of college and retirement savings. That’s no small task, especially when you stop to consider the big price tags associated with each, as well as the complexities of calibrating two separate pots of money with two different time horizons.

Even so, you tend to see less information about how mid-career accumulators should invest and manage their finances differently than their younger and older counterparts. Like 20- and 30-somethings, mid-career accumulators still have a decent amount of human capital, or earnings power. And with a runway of 15 or 20 years until retirement—and perhaps 25 or 30 more years in retirement—they can usually afford to take plenty of equity

risk with their investment portfolios.

What follows are some priorities to keep in mind if you’re a mid-career accumulator looking to make sure you’re on the right track with your financial and investing life.

Nurture your human capital

Investing in human capital—via additional education or training—is close to a slam-dunk for early career accumulators.

If you can increase your earnings power with such an investment, you have a long time until retirement to benefit from it. The calculus isn’t as simple as you get older, which helps explain why med schools and high-priced MBA programs aren’t jam-packed with people in their 40s and older. Higher lifetime earnings may not offset the outlay of money and time for costly training later in life.

Yet mid-career accumulators should still make an ongoing investment in their own human capital—taking advantage of continuing education programs and conferences to enhance their skills, networking, and simply staying current on the latest news and developments in their fields.

Balance college funding with other goals

Balancing college funding against saving for retirement is arguably the biggest financial challenge facing many mid-career accumulators. Many parents naturally feel the tug of shouldering at least a portion of their children’s college costs.

How to reconcile these competing goals? We’d advise putting retirement readiness front and center on your financial dashboard. The reason is that if retirement is drawing close and you have a shortfall in your savings, you’ll have fewer levers available to you than is the case if your child gets close to matriculation and you haven’t socked away the tuition.

Protect what you have

The more assets you amass, the more important it is to protect what you have.

The same basic insurance types that were valuable in your 20s and 30s—health, disability, property and casualty, and life insurance—remain every bit as essential as you head into your 40s and 50s.

Homeowners also should consider a personal liability policy to cover them in case an accident or other incident should oc-

cur on their property. Finally, the 50s are a good life stage to assess whether a longterm care insurance policy makes sense in your situation; the longer you wait, the higher your insurance costs are apt to rise and the more likely you are to encounter a health condition that could disqualify you from purchasing the insurance.

Combat lifestyle creep and step up your savings

The 40s and 50s often are considered the peak earnings years. But with higher earnings, it’s easy to let “lifestyle creep” gobble up every bit of your extra income.

One way to help ensure that your savings steps up with your income by switching on the auto-increase feature of your company retirement plan; that way your 401(k) contributions will increase each time you get a raise and you won’t have a chance to get accustomed to the higher income.

At age 50 you also can start taking advantage of what are called catch-up contributions, which allow you to steer an additional $6,000 per year to your 401(k), 403(b), or 457 plan and an Morningstar extra $1,000 into an IRA.

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PRE-RETIREES

CASE STUDY:

Portfolio for conservative retirement savings

S

BY CHRISTINE BENZ

eventy-five years ago, the average remaining life expectancy for a man reaching age 65 was 12.7 years, and 14.7 years for a 65-year-old woman, according to Social Security Administration data.

Fast-forward to today and those numbers have increased to 19.3 years and 21.6 years, respectively.

Those life expectancy gains are, of course, largely a positive. But when you combine longer life spans with the fact that more and more people are coming into retirement with Social Security as their only guaranteed income source, it’s not hard to see why such a large swath of the population is concerned about outliving its assets.

Because low bond yields portend meager returns from the asset class in the decades ahead, a very conservative, cash- and bond-heavy portfolio is unlikely to cut it for most pre-retirees. To help improve their portfolios’ long-term return potential and preserve purchasing power, people closing in on or already in retirement absolutely need to hold a healthy allocation to stocks.

That thinking explains why the Conservative Saver portfolios—geared toward still-working individuals who expect to retire in 2020 or thereabouts— maintains a more than 50 percent weighting in stocks. As with previous portfolios, I used Morningstar’s Lifetime Allocation Indexes to help set the baseline allocations.

Portfolio details

For the Conservative Saver Portfolio, I targeted a roughly 50 percent stock weighting. For equity exposure, I held on to the same funds employed in the Moderate Saver Portfolio, albeit in smaller allocations.

Individuals at this life stage might also start setting up their portfolios by anticipated income needs, as demonstrated with the bucket approach, which is covered in the next section of this guide.

With retirement five to 10 years into the future, it’s too early to start raising cash for in-retirement living expenses; at today’s very low yields, the opportunity cost of doing so is simply too great. But pre-retirees might consider steering part of their fixed-income sleeves to a shortterm bond fund that could be readily converted into cash. After all, having sufficient short-term assets in the portfolio can help mitigate sequencing risk— the chance that a retiree could encounter a lousy market right out of the box.

The mutual fund portfolio

10%: Primecap Odyssey Growth (POGRX) 10%: Vanguard Dividend Appreciation (VDADX) 10%: Oakmark Fund (OAKMX) 7%: Vanguard Extended Market Index (VEXAX) 10%: Vanguard Total International Stock Index (VTIAX) 4%: Oakmark International Small Cap (OAKEX) 30%: Metropolitan West Total Return Bond (MWTRX) 7%: Fidelity Short-Term Bond (FSHBX) • 12%: Vanguard Inflation-Protected Securities (VAIPX)

The ETF portfolio

33%: Vanguard Total Stock Market Index ETF (VTI) 5%: Vanguard Small-Cap Value ETF (VBR) 10%: Vanguard FTSE Developed Markets ETF (VEA) 4%: Vanguard FTSE Emerging Markets ETF (VWO) 30%: iShares Core Total USD Bond Market ETF (IUSB) 11%: Vanguard Short-Term Inflatio Protected Securities ETF (VTIP) 7%: Vanguard Short-Term Bond ETF (BSV)

How to use

The key goal of all of my model portfolios is to depict sound asset-allocation and portfolio-management principles.

Thus, individuals who are closing in on retirement can use the Conservative Saver portfolios to help assess their portfolios’ positioning. But it’s worth noting that the portfolios won’t be a good fit for all pre-retirees. For example, those who will be relying on pensions for much of their in-retirement living expenses, or those who know they can handle the volatility that comes along with a stockheavy portfolio, will likely want to steer more than half of their portfolios to stocks.

I also developed the portfolios without consideration for tax efficiency—that is, I assumed they would be held inside of a tax-sheltered wrapper of some kind, such as an IRA. Investors who intend to hold their portfolios inside of a taxable account would want to put a greater emphasis on tax efficiency, emphasizing index funds and ETFs on the Morningstar equity side, for example.

How to bridge a

RETIREMENT SHORTFALL

I

BY CHRISTINE BENZ

f you want to get yourself thoroughly depressed, spend a little time looking at statistics about Americans’ retirement preparedness. True, retirement-account balances have rebounded significantly since the financial crisis, contributing to an increase in workers’ confidence that they’ll be able to afford a comfortable retirement.

But other data are more sobering.

Fidelity’s Retirement Preparedness Measure, which takes into account current savings rates and account balances, shows that less than half of all Americans are going to be able to maintain their current standards of living in retirement. A recent report from the U.S. Government Accountability Office issued noted that about half of all Americans age 55 or older have no retirement savings, such as IRAs or 401(k)s.

Clearly, many people are hurtling toward a shortfall or living through one.

And for people who are dramatically undersaved and largely reliant on Social Security for in-retirement living expenses, there’s no getting around the fact that their standard of living in retirement is going to be lower than it was when they were working.

Many other workers have some retirement savings—just not enough. I’ve noticed that people in that position tend to adopt one of a handful of tactics. The first set is defeatist: “My kids will just have to take care of me.” The second set is scrappy: “I’m just going to keep on working.” The last group of people are looking to their investment portfolios to do the heavy lifting, hoping against hope that some combination of the right asset allocation and good investment picks will help make up for the shortfall.

I’d propose a fourth course of action. Rather than looking to a single blockbuster solution to help make up for a savings gap, what if you were to

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consider a little bit of several prudent strategies—being willing to cut your standard of living a bit in retirement, working a bit longer, and investing a bit better, for example? The virtue of taking several small steps—rather than relying on a single “Hail Mary” action—is that if one of the variables doesn’t play out as you thought it would, you may still be able to save your plan.

Meet the shortfall coverers

Let’s run through the key variables that investors have to choose from if, based on their current savings and savings rates, it looks like there’s a risk that their retirement assets will fall short.

Work longer: As pre-retirees have no doubt heard, working even a few years past traditional retirement age can deliver a three-fer on the financial front, allowing additional savings, fewer years of portfolio drawdown, and perhaps delayed Social Security filing. Yet as attractive as working longer looks by the numbers, it’s a poor idea to make it the sole fallback plan, as many workers who plan to work longer are not able to.

Delay Social Security: This is another exceptionally powerful lever, allowing individuals to pick up a roughly 8 percent increase in benefits for every year they delay Social Security filing beyond their full retirement ages up until age 70. In order to pull this off, however, an individual may need to work longer or draw from the portfolio earlier.

Save more before retirement: The good news is that from a household budgetary standpoint, many individuals are best equipped to crank up their savings rates later in their careers. They’re often in their peak earnings years, and other big-ticket pre-retirement expenses, such as home purchases and college funding, may be in the rearview mirror. The bad news is that with a shorter time horizon, those newly invested dollars will have less time to compound before they’ll need to withdraw them; the tax benefits that

one gets from using tax-advantaged retirement savings vehicles like IRAs and 401(k)s also matter less (especially for tax-deferred contributions that entail RMDs) later in life. That doesn’t mean that late-start retirees shouldn’t bother with additional contributions if they can swing them, though: Even an additional $5,000 invested annually for 10 years, earning a modest average return of 4 percent, would translate into more than $60,000 additional dollars in retirement.

Spend less during retirement: Generally speaking, people who earned higher incomes will have more wiggle room in lowering their in-retirement expenses than people with lower incomes. The simple reason is that the former group is apt to have more discretionary expenses—and therefore could do more belt-tightening—than the latter group. Being willing to relocate to a cheaper home and/or a less-expensive location c an deliver one of the biggest-ticket cost savings available to retirees.

Tweak investments: Many pre-retirees confronting a shortfall focus their energies here, and a portfolio with a heavier stock mix will tend to have a higher long-term return than a more conservative one. Yet it’s a mistake not to temper a pre-retirement portfolio’s asset mix with safer investments, and that’s particularly true in market environments that feature not-cheap equity valuations (like the current one).

Lower investment costs: This one’s a gimme. Lower mutual fund expenses are correlated with better returns, so why wouldn’t you work to bring your portfolio’s total costs down? Lowering costs can be particularly advantageous as you enlarge your portfolio’s stake in safer investments like bonds, where absolute investment returns are apt to be fairly low and the differential between very strong- and very poor-performing investments can boil Morningstar down to expenses.

PRE-RETIREES: Road Map

t’s no wonder that so many investors seek out extra guidance at this life stage, because decumulation is fundamentally more complicated than building up a portfolio in advance of retirement. Investors hurtling toward retirement quite reasonably wonder about the viability of their plans— whether they’ll have enough and how much they can take out of their portfolios each year—as well as the structure of their portfolios. In an era in which yields have dropped steadily downward for the better part of three decades, it’s not intuitively apparent how to structure a portfolio to deliver the necessary cash flows for retirement.

As you plot out your strategy at this life stage, here are the key tasks to tackle.

Nourish your human capital

In previous articles in this guide geared toward early- and mid-career accumulators, we emphasized the importance of continuing to invest in your human capital—your lifetime earnings power. Keeping abreast of the latest technology developments—both

inside and outside of your workplace— also is crucial. After all, the best thing you can do to improve the financial viability of your retirement plan is to put in as many years in the workplace as you can.

Start mulling your Social Security strategy

Staying in the workforce up to or beyond traditional retirement age has another salutary benefit: It can help you delay filing for Social Security, thereby enlarging your benefit when you eventually do file. The Social Security Administration’s Retirement Estimator allows you to model out your Social Security benefits based on various Social Security start dates.

Married couples should take special care to strategize about Social Security together, with an eye toward enlarging their total lifetime benefits from the program. (If one spouse is younger and will gain a larger benefit from a spousal benefit than his or her own benefit, delaying receipt of benefits will be particularly advantageous for the older, higher-earning spouse.)

Maintain your safety net

The usual insurance recommendations apply for the years leading up to retirement: property and casualty, personal liability, and health and disability, of course. If your children are grown and off your payroll, it’s also wise to revisit your need for life insurance at this stage.

Long-term care insurance may be prohibitively expensive by the time you reach your early 60s, or you may have encountered a health condition that disqualifies you from buying it. But it’s still worth pricing out coverage, especially if you have built up a sizable but not enormous nest egg.

Maintaining an adequate emergency fund remains important at this life stage.

Because higher-income and/or more specialized jobs often are more difficult to replace than is the case for people who are earlier in their careers, consider holding at least a year’s worth of living expenses in liquid assets. There’s an opportunity cost to holding too much cash, of course, but having an adequate cushion will keep you from having to raid your retirement assets Morningstar prematurely.

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RETIREES

COMMENTARY

by Christine Benz

Blueprint for the future Helping you meet the challenge of retirement

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he financial challenges are stacking up for retirees and retiree wannabes.

First, there’s a good news/bad news story: The length of the typical retirement for U.S. citizens has been on the rise over the past several decades, from just 10 years in 1940 to 18 years in 2000.

Meanwhile, the average number of years worked has declined from 50 in 1940 to 42 in 2000.

That means more of us have more free time to pursue what we love later in life, whether that’s travel, spending time with grandkids or kicking back with a good book.

But the shrinking ratio of working years to years spent in retirement also heightens the need to save more for retirement, as well as to get more mileage out of what we manage to save.

Further compounding the financial challenges of retirement is the ebbing of pensions, especially in the private sector. In 2011, just 3 percent of private-sector workers were covered exclusively by a pension (as opposed to some other type of company retirement plan), according to data provide by the Employee Benefit Research Institute, down from 31 percent in the late 1970s.

Yet participation in 401(k) and other defined-contribution plans hasn’t fully picked up the slack: Fidelity Investments, one of the largest 401(k) providers, recently reported that the average 401(k) balance was $91,000.

As you might expect, the average 401(k) balances for older participants were higher, and retirement savers may have other retirement assets stashed elsewhere. But it’s still safe to say that the typical American hasn’t saved nearly enough for retirement.

Add in barely positive CD yields and a profitable — though volatile — stock market, and it’s not too hard to see why 77 percent of respondents in a 2010 Allianz survey said they were more worried about running out of money than they were of dying.

Creating a successful financial plan for retirement needn’t be a black hole of worry, though. Rest assured that wherever you are in the process — whether you’re a 20-something who has just begun to contribute to a 401(k) or you’re already retired and drawing living expenses from your portfolio — you can still take steps to improve the viability of your plan.

Helping you do that is the focus of this special retirement-planning supplement on in the next 12 pages, created by Morningstar, Inc. Since its founding in 1984, Morningstar’s overarching mission has been to help investors reach their financial goals. As director of personal finance for Morningstar and editor of this supplement, I’ve culled research from Morningstar’s internal retirement and investment experts as well as outside researchers. I also drew heavily from some of my own work, which appears several times of week on Morningstar.com, Morningstar’s website for individual investors. I’ve aimed to include practical, easy-to-implement ideas for retirement planning across life stages.

No matter your life stage or level of investment acumen, I’m confident you can find strategies in this supplement that you’ll be able to take and run with.

Christine Benz is director of personal finance for Morningstar and senior columnist for Morningstar.com. She contributes several articles and videos to the website each week, focusing primarily on retirement planning and investment-portfolio strategies.

RETIREMENTPORTFOLIO

WITHDRAWAL

S

MISTAKES TO AVOID

BY CHRISTINE BENZ

ome errors in retirement-portfolio planning fall into the category of minor infractions rather than major missteps. Did you downplay foreign stocks versus standard advice about how to put together a portfolio, or hold a bit more cash than you needed? It’s probably not going to have a big impact on whether your money lasts throughout your retirement years.

But other errors can have more serious repercussions for the viability of retirement-portfolio plans.

Withdrawal rates — or spending rates, as I prefer — are another spot where retiree-portfolio plans can go badly awry.

If a retiree takes too much out of his or her portfolio at the outset of retirement — and, worse yet, that overspending coincides with a difficult market environment — he or she can deal his or her portfolio a blow from which it may never recover. Other retirees may take far less than they actually could, all in the name of safety. While their children and grandchildren may thank them for all they left behind, the risk is that they didn’t fully enjoy enough of their money during their lifetimes.

Here are a few common mistakes in the realm of retirement-portfolio withdrawals, as well as tips on how to avoid them.

MISTAKE 1: Not adjusting with your portfolio’s value and market conditions Some of the most important research in retirement-portfolio planning over the past decade has come in the realm of withdrawal rates. One of the conclusions of all of this research? Even though the popular “4 percent rule” assumes that a retiree withdraws 4 percent of his or her portfolio at the outset of retirement, then gradually adjusts that amount for inflation, retirees would be better off staying flexible about their withdrawals. That means they should withdraw less when the markets and their investments are down, while potentially taking more when the market and their portfolios are up.

What to do instead: The simplest way to tether your withdrawal rate to your portfolio’s performance is to withdraw a fixed percentage, versus a fixed dollar amount adjusted for inflation, year in and year out. That’s intuitively appealing, but this approach may lead to more radical swings in spending than is desirable for many retirees. It’s possible to find a more comfortable middle ground by using a fixed percentage rate as a baseline but bounding those withdrawals with a “ceiling” and a “floor.” A qualified financial advisor can help you determine if your withdrawal strategy is reasonable given the amount of assets that you have.

MISTAKE 2: Not building in a “fudge factor” Another drawback to employing a fixed-dollar withdrawal method — especially if the viability of your plan revolves around a fixed annual dollar amount that’s too low — is that it won’t account for the fact that your actual expenses are likely to vary from one year to the next. Try as you might to anticipate them, discretionary expenditures like travel, new car purchases or unplanned outlays for home repairs or medical expenses have the potential to throw your planned withdrawal rate off track.

If you calibrate your anticipated spending based on your basic monthly outlay alone (for groceries and utilities, your property-tax bill, and so forth) and don’t leave room for these periodic unplanned expenses, your actual spending rate in most years is apt to run higher than your planned outlay. In short, a withdrawal plan that looked sustainable on paper actually may not be.

What to do instead: Smart retirement planning means forecasting not just your regular budget items but those lumpy outlays, too. In addition to building those extraneous items into your budget, it’s also wise to add a “fudge factor” in case those unplanned outlays exceed your forecasts. Armed with that more-accurate depiction of your anticipated spending, you can then test the viability of your withdrawal rate.

MISTAKE 3: Not adjusting with your time horizon Taking a fixed amount from a portfolio — whether you’re using a fixed dollar amount or a fixed percentage rate — also neglects the fact that, as you age, you can safely take more from your portfolio than you could when you were younger. (That assumes, of course, that you’re planning to spend most of your portfolio and are not planning to leave behind large sums for your heirs or for charity.) The original “4 percent” research assumed a 30-year time horizon, but retirees with shorter time horizons (life expectancies) of 10 to 15 years can reasonably take higher amounts.

What to do instead: To help factor in the role of life expectancy, David Blanchett, Morningstar Investment Management’s head of retirement research, has suggested that retirees can use the IRS’ tables for required minimum distributions as a starting point to inform their withdrawal rates. That said, those distribution rates may be too high for people who believe their life expectancy will be longer than average.

MISTAKE 4: Not adjusting based on your portfolio mix Many retirees take withdrawal-rate guidance, such as the 4 percent guideline, and run with it, without stopping to assess whether their situations fit with the profile underpinning that

guidance. The 4 percent guideline, for example, assumed a retiree had a balanced stock/bond portfolio. But retirees with more-conservative portfolio mixes should use a more-conservative (lower) figure, whereas those with more-aggressive asset allocations might reasonably take a higher amount.

What to do instead: Be sure to customize your withdrawal rate based on your own factors, including your portfolio mix. Here again, a financial advisor can help you create a customized spending target based on your mix of investments.

MISTAKE 5: Not factoring in the role of taxes The money you’ve saved in tax-deferred retirement-savings vehicles might look comfortingly plump. However, it’s important to factor in the role of taxes when determining your takehome withdrawals from those accounts.

What to do instead: Here’s another area where it pays to be conservative in your planning assumptions; to be safe, it’s valuable to assume a higher tax rate than you might actually end up paying. Pre-retirees and retirees may also benefit from consulting with a tax advisor or a tax-savvy financial advisor to help stay within the lowest possible tax bracket throughout their retirement years; such advisors may also be able to help retirees optimize their sequence of withdrawals from various account types to keep tax bills down.

MISTAKE 6: Staying wedded to your portfolio’s income payout Many retirees operate with the assumption that they can spend whatever income distributions their portfolios kick off — no more, no less. As yields on safe securities like CDs and short-term bonds have shrunk over the past several decades, they’ve had to make do with less or have ventured into higher-yielding securities with higher risk. They assume that as long as they spend only their portfolio’s income distributions, their retirement plans will always be safe.

However, the distinction between income distributions and principal withdrawals is an artificial one.

What to do instead: While there’s no one single “right” way to manage a portfolio to deliver your spending needs in retirement, it’s wise to have a plan.

Will your withdrawal come from income distributions, periodic withdrawals of capital (through selling highly appreciated securities like stocks, for example) or a combination of the two?

The method that Morningstar favors is building a portfolio with an emphasis on long-term total return; retirees can then see how far any income distributions from that portfolio take them, and then use proceeds from rebalancing their portfolios to help Morningstar make up for the rest.

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Key decisions for your retirement withdrawal strategy

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ou’ve accumulated what seems like a sufficiently sized nest egg coming into retirement. The next step is to figure out how to get your money out of it.

At first blush, the answer seems simple: Buy income-producing securities — bonds and dividend-paying stocks — and call it a day. When yields are higher, so is your payday; when they’re lower, you have to get by on less. If you have a lot of money and yields are good, you may be able to get away with never touching your principal during your lifetime; the money then can pass to kids, grandkids or charity.

That’s certainly one way to do it, but it’s not the only retirement spending strategy out there. To home in on the right one, retirees need to consider two sets of questions: first, the extent to which they’re comfortable with a fluctuating payday and, second, whether they want their paycheck to come from income alone or other sources, as well.

Investors often conflate these two questions — for example, they assume that if they’re focusing on income production, they’ll need to put up with some variability in their payday as prevailing market yields ebb and flow. In reality, it’s possible to employ an income-centered strategy that delivers a steady dollar paycheck. Meanwhile, the opposite strategy also is viable: building a total-return-centered portfolio that delivers a variable, market-sensitive payday. Retirement researchers generally consider variable distribution methods as more sustainable than withdrawing a fixed dollar amount because they’re more market-sensitive.

To arrive at the best decision for you, consider the following: Will your withdrawal amount be fixed, variable or a blend?

Do you want a paycheck in retirement that is more or less static, save for an inflation adjustment to help preserve the purchasing power of what you withdraw? Or are you OK with varying paychecks, depending on how your portfolio is performing? Let’s walk through the pros and cons of each of those approaches and also consider a hybrid strategy that blends these two approaches.

The fixed-dollar amount: Using this strategy, the retiree takes a specific percentage of his or her portfolio in year one of retirement, then inflation-adjusts that dollar amount in subsequent years. That’s the spending approach embedded in the 4 percent “rule” for retirement spending. For example, say a retiree has an $800,000 portfolio and is using a starting withdrawal of 4 percent.

Year one spending is $32,000; year two spending is $32,960 (the initial $32,000 plus a 3 percent inflation adjustment).

Pros: A reliable income stream; comes closest to simulating the paycheck that many retirees earned while they were working; is the strategy embedded in much of the academic literature on withdrawal rates.

Cons: Not sensitive to market fluctuations; taking too much in down years could leave less in place to bounce back when the market recovers.

The fixed percentage method: Using this method, the retiree takes a preset percentage of the portfolio per year.

Assuming an $800,000 portfolio, the retiree taking a 4 percent fixed percentage of the portfolio would have $32,000 in year one. But if the portfolio increased in value to $900,000, the payday would also increase to $36,000.

Pros: Ties in with portfolio values and market performance; market-sensitive spending strategies generally considered more sustainable than those that don’t consider market performance; virtually guarantees retiree won’t run out of money.

Cons: Translates into a fluctuating paycheck, which may not suit retiree’s lifestyle considerations; taking a fixed percentage from a shrinking pool may not be enough to live on in some years.

The hybrid method: Such strategies — and there are a few variations — attempt to deliver a fairly steady paycheck while also baking in some market sensitivity. One of the simplest strategies to implement, one that T. Rowe Price has advanced, would be to spend a relatively static dollar amount while foregoing the inflation adjustment in down-market years. Another strategy, discussed in research by Jonathan Guyton and William Klinger, assumes a fixed-percentage withdrawal method with “guardrails” to ensure that spending never goes above a given ceiling or floor.

Pros: Attempts to deliver a fairly stable cash flow while also staying sensitive to portfolio fluctuations.

Cons: Can be more complicated to understand and implement; simple methods, like the T. Rowe Price strategy, help improve the odds that a retiree won’t run out of money, but they Morningstar don’t guarantee it.

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    

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BY CHRISTINE BENZ

s inveterate watchers of sitcom reruns (and a real-life Felix/Oscar combination), my sister and I loved “The Odd Couple” (with Tony Randall, left, as Felix Unger) while we were growing up. One of our favorite episodes featured a courtroom sequence in which Felix berates a witness to “never assume,” and proceeds to use the chalkboard to demonstrate what happens when you do. More years later than I care to admit, the mere mention of the word “assume” makes me smile.

But assumptions aren’t always a laughing matter, and that’s certainly true when it comes to retirement planning, where “hope for the best, plan for the worst” is a reasonable motto. Incorrect — and usually too rosy — retirement-planning assumptions are particularly problematic because by the time a retiree or pre-retiree realizes her plan is in trouble, she may have few ways to correct it; spending less or working longer may be the only viable options.

What follows are some common — and dangerous — assumptions that individuals make when planning for retirement, as well as some steps they can take to avoid them.

DANGEROUS ASSUMPTION 1: That stock and bond market returns will be rosy Most retirement calculators ask you to estimate what your portfolio will return over your holding period.

It may be tempting to give those numbers an upward nudge to help avoid hard choices like deferring retirement or spending less, but think twice.

To be sure, stocks’ long-term gains have been pretty robust. The S&P 500 generated annualized returns of about 10 percent in the 100-year period from 1915 through the end of last year, and returns over the past 20 years have been in that same ballpark. But there have been certain stretches in market history when returns have been much less than that; in the decade ended in 2009, for example — the so-called “lost decade” — the S&P 500 actually lost money on an annualized basis.

The reason for stocks’ weak showing during that period is that they

were pricey in 2000, at the outset of the period. Stock prices aren’t in Armageddon territory now, yet neither are they cheap.

What to do instead: Prudent investors may want to ratchet down their market-return projections somewhat just to be safe. Morningstar equity strategist Matt Coffina has said that long-term, inflation-adjusted returns in the 4.5 percent to 6 percent range are realistic for stocks. Vanguard founder Jack Bogle’s forecast for inflation-adjusted stock returns is in that same ballpark.

Investors will want to be even more conservative when it comes to forecasting returns from their bond portfolios. Starting yields have historically been a good predictor of what bonds

7 FINANCIAL CHALLENGES FOR RETIREES Withdrawals A too-high withdrawal rate can force a retiree to make do with less later in life. The right withdrawal rate depends on portfolio mix, market performance.

Longevity Long retirement horizon — a couple aged 65 has 25 percent chance of one partner living to age 96.

Solvency Shrinking percentage of workers covered by pension plans as Social Security and Medicare under strain.

Savings Under-funded 401(k) accounts.

Most Americans have an enormous savings gap.

Inflation Erodes the value of savings and reduces returns. Health care inflation historically is higher than the Consumer Price Index.

Market volatility Uncertain returns and income.

Market performance early in retirement determines portfolio’s long-term viability.

Retiree spending Spending on food and health care often increase in retirement. Long-term care expenses are impossible to predict.

might earn over the next decade, and right now they’re pretty meager — roughly 2 percent or 3 percent for most high-quality bond funds. That translates into a barely positive real (inflation-adjusted) return.

DANGEROUS ASSUMPTION 2: That inflation will be mild or nonexistent In a related vein, currently benign inflation figures may make it tempting to ignore, or at least downplay, the role of inflation in your retirement planning. Like robust return assumptions, modest inflation assumptions can help put a happy face on a retirement plan.

But should inflation run hotter than you anticipated in the years leading up to and during your retirement, you’ll need to have set aside more money and/or invested more aggressively in order to preserve your purchasing power when you begin spending from your portfolio.

What to do instead: Rather than assuming that inflation will stay good and low in the years leading up to and during retirement, conservative investors should use longer-term inflation numbers to help guide their planning decisions; 3 percent is a reasonable starting point. And to the extent that they can, investors should customize their inflation forecasts based on their actual consumption baskets.

For example, food costs often are a bigger slice of many retirees’ expenditures than they are for the general population, while housing costs may be a lower component of retirees’ total outlay, especially if they own their own homes.

The possibility that inflation could run higher than it is today also argues for owning investments that help you preserve purchasing power once you begin spending your retirement assets. That means stocks, which historically have had a better shot of outgaining inflation than any other asset class, as well as Treasury Inflation-Protected Securities and I-Bonds, commodities, precious-metals equities and real estate.

DANGEROUS ASSUMPTION 3: That you’ll be able to work past age 65 Never mind how you feel about working longer: Continued portfolio contributions, delayed withdrawals and delayed Social Security filing

A NEW VOCABULARY FOR R

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hen it comes to their finances in retirement, most people want the same things.

They want to be able to enjoy a lifestyle on par with, if not better than, the one they had when they were working. They want to have the money to pay for travel and hobbies that give them joy without having to skimp in other areas.

They want their assets to last for their lifetimes, with possibly some left over for loved ones or favorite charities. Most of all, retirees and pre-retirees want to put their money in its place: With busy lives to lead, they just don’t want to worry about it.

Yet, despite all of those commonalities, there’s a tremendous range of opinion about specific strategies for achieving the above-mentioned goals. Certainly, there’s more than one way to get it done, and the fact that retirees and pre-retirees debate various strategies can signal that they have a healthy conviction in their approaches. But if you read between the lines, some of these disagreements are more semantic than they are real. And Morningstar can’t help but wonder if that’s because a lot of the terms we use to discuss retirement are outmoded — a vestige of the days when CDs had double-digit yields and pensions were plentiful.

The new world of retirement

planning calls for more flexible and inclusive terms. Herewith are some retirement terms that Morningstar would like to see retirees and pre-retirees swap into their vocabularies, along with terms we’d like to see on the chopping block because they fan the flames of confusion.

In: Spending rate Out: Withdrawal rate “Spending rate” gets at the notion that there’s more than one way to get the money you need from your portfolio in retirement. Yes, you can extract your money through outright withdrawals of principal, as the term “withdrawal rate” suggests, but you also can get it from spending your income and dividend distributions rather than reinvesting them back into the portfolio. Many retirees sensibly take a variety of tacks to generate the money they need from their portfolios, using income and dividend distributions to provide them with a baseline of living expenses and tapping principal to generate any excess income required.

The term “spending rate” also telegraphs the concept that total-return investors withdrawing principal from their portfolios aren’t the only ones who need to concern themselves with the safety and the sustainability of their spending. Income-minded investors might automatically tune out any discussion of withdrawal rates, assuming that the term refers

to withdrawal of principal. (In fact, we recently heard an income-minded investor say that her withdrawal rate was 0 percent because she can subsist on her portfolio’s income alone.)

But most of the research surrounding safe withdrawal rates — including the 4 percent rule — doesn’t differentiate about whether the retiree gets his or her money from bond and dividend income or withdrawals of principal.

The effect of 4 percent taken from a portfolio is the same regardless of whether it comes in the form of dividend and income distributions that are spent rather than reinvested or whether it comes from withdrawals of principal after reinvesting income, dividends and capital gains distributions.

In: Retirement cash flow Out: Retirement income Retirees often obsess about generating income from their portfolios, conflating their need to replace the income they once earned from their salaries with a need to invest their whole portfolios in income-producing securities. This phenomenon probably has its roots in a more favorable yield environment: When bond yields were higher, many retirees could readily generate the cash they needed from their portfolios using money markets and bonds.

It generally makes sense to increase stakes in income-producing securities like bonds and divi-

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can help improve the likelihood that you won’t run out of money during retirement. Given those considerations, as well as the ebbing away of pensions, increasing longevity and the fact that the fifinancial crisis did a number on many pre-retirees’ portfolios, it should come as no surprise that older adults are pushing back their planned retirement dates. Whereas just 11 percent of individuals surveyed in the 1991 Employee Benefit Research Institute’s Retirement Confidence Survey said they planned to retire after age 65, that percentage had tripled — to 33 percent — in the 2014 survey.

In 1999, just 5 percent of EBRI’s survey respondents said they planned to never retire, whereas 10 percent of the 2014 respondents said that.

Yet there appears to

be a disconnect between pre-retirees’ plans to delay retirement and whether they actually do. While a third of the workers in the 2014 survey said they planned to work past age 65, just 16 percent of retirees said they had retired post-age 65. And a much larger contingent of retirees — 32 percent — retired between the ages of 60 and 64, even though just 18 percent of workers said they plan to retire that early. The variance owes to health considerations (the worker’s, his or her spouse’s or parents’), unemployment or untenable physical demands of the job, among other factors.

What to do instead: While working longer can deliver a three-fer for

your retirement plan — as outlined above — it’s a mistake to assume that you’ll be able to do so. If you’ve run the numbers and it looks like you’ll fall short, you can plan to work longer while also pursuing other measures, such as increasing your savings rate and scaling back your planned in-retirement spending.

At a minimum, give your post-age-65 income projections a haircut to allow for the possibility that you may not be able to — or may choose not to — earn as high an income in your later years as you did in your peak earnings Morningstar years.

R RETIREMENT PLANNING dend-paying stocks as retirement draws near, as such securities often have more stability than stocks without dividends. But retirees can meet their cash flow needs from a variety of sources: Social Security and pension payments, annuity income, rebalancing proceeds, withdrawals of principal and, yes, dividend and income distributions.

The broader the base of cash-flow resources, the greater the diversification and flexibility to maximize the investment portfolio’s risk/reward profile.

In: Retirement life-cycle fund Out: Target-date fund The term “target-date fund” definitely has the potential to mislead.

For starters, the term “target” could incorrectly promote the notion that such funds will deliver a specific level of guaranteed income in retirement.

Indeed, in a Securities and Exchange Commission survey, only 36 percent of respondents correctly indicated that target-date funds do not provide guaranteed income in retirement.

Even some investors who own these funds appear to be confused about what “target date” means. Some of the SEC survey respondents thought target date refers to the date that the fund will begin delivering that guaranteed income stream, while others thought it was the date when the fund would reach its most conservative investment mix. Just 32 percent of target-date fund owners and 27 percent of non-owners correctly indicated that the target date

A GLOSSARY OF SOCIAL SECURITY TERMS Average Indexed Monthly Earnings The dollar amount used to calculate your Social Security benefit based on your past earnings, which are adjusted for wage growth.

Credits Earned when you work and pay into Social Security. 40 credits are typically needed to qualify for benefits.

Delayed Retirement Credits Credits earned for delaying claiming of Social Security benefits beyond full retirement age. These credits translate into a roughly 8% increase in benefits for every year delayed past full retirement age.

Disability Benefits Available from Social for people who are not yet full retirement age, have earned sufficient Social Security credits, and have either a mental or physical disability that prevents them from working.

was supposed to be their anticipated retirement date.

The term “retirement life-cycle fund” doesn’t exactly trip off the tongue, but it helps address some of the confusion surrounding the “target date” term.

For one thing, “life cycle” conveys that the asset mix of the fund will change throughout one’s accumulation years and perhaps even into retirement. And

Full Retirement Age This is between 65 and 67, depending on when you were born. Technically you can claim Social Security any time after age 62, but you’ll get smaller monthly checks than if you’d waited until full retirement age.

Primary Insurance Amount The monthly amount you’ll receive if you’re a retired worker who begins receiving benefits at full retirement age.

Spousal Benefit A Social Security benefit paid to a spouse (or former spouse, assuming the marriage lasted 10 years or more).

The spousal benefit is equal to 50% of the worker’s benefit, assuming he or she waited until full retirement age to claim benefits. Spouses may also claim benefits based on their own earnings histories; they are free to choose the higher payout.

removing the word “target” helps dispel the idea that these funds’ results are guaranteed.

In: Social Security “insurance” Out: Social Security income Social Security is an important source of income — er, cash flow — for many retirees, and while it’s not the same as an insurance policy you would buy from

Let’s replace these terms as they spread confusion an agent, the program’s benefits do have insurance-like qualities that are worth considering when you map out your retirement plan.

Social Security provides more than just an income stream — it’s an income stream that’s guaranteed throughout your retirement. That stands in contrast to your portfolio, which may at some point become exhausted due to unexpected expenses, poor market returns or an unexpectedly long life span.

Social Security will continue paying as long as you continue breathing. So if you think of Social Security as a form of longevity “insurance,” it helps clarify your decision about when to start taking it. If you expect a long life span, you probably want more insurance, and that argues for starting benefits at full retirement age or later; that way you can earn a higher benefit. If you think you need less insurance, you may start taking benefits sooner.

As with an insurance purchase, a current or, particularly, future Social Security recipient will want to consider the financial strength of the counterparty (in this case, the U.S. government) and the likelihood that benefits could be effectively reduced over time.

If you are notably pessimistic on this front, then you may choose to have Social Security “insurance” play a smaller role in your retirement financial plan, which may necessitate a higher savings rate leading up to retirement or a lower spending rate in retireMorningstar ment.

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THE

GET A TAX SMART PLAN FOR INRETIREMENT WITHDRAWALS

BUCKET APPROACH TO

There isn’t a cookie-cutter answer to deciding which accounts to pull from first because an investor’s strategy will be determined by age and tax rate when taking the withdrawal. A key focus when developing your withdrawal strategy should be preserving the tax-saving benefits of your tax-sheltered investments for as long as you possibly can.

RETIREMENT ALLOCATION

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hose who lived through the 1970s and ’80s no doubt find their photographs from those decades to be cringe-worthy. But while few may wish to repeat a fashion era marked by pastel-colored suits and big hair, one aspect of those bygone decades is appealing — substantially higher interest rates than those that prevail today. The average interest rate on a sixmonth certificate of deposit was 9.1 percent in 1970 and 13.4 percent in 1980. Of course, inflation was high then, too, but those higher rates, plus the prevalence of pensions, allowed many retirees to generate livable income streams without invading their principal or taking risks in stocks.

But three decades’ worth of declining interest rates have dragged yields way down, dramatically compounding the challenge for retirees. With infinitesimal yields on money market accounts and high-quality bonds, retirees’ choices are stark: To be able to afford retirement, they can plan to delay the date, save more, reduce their standards of living or take more risks with their portfolios.

The “Bucket Approach” to retirement-portfolio management, pioneered by financial planning guru Harold Evensky, aims to meet those challenges, effectively helping retirees create a paycheck from their investment assets. Whereas some retirees have stuck with an income-centric approach but have been forced into ever-riskier securities, the bucket concept is anchored on the basic premise that assets needed to fund near-term living expenses ought to remain in cash, dinky yields and all. Assets that won’t be needed for several years or more can be parked in a diversified pool of long-term holdings, with the cash buffer providing the peace of mind to ride out periodic downturns in the long-term portfolio.

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(The all-important) Bucket 1

The linchpin of any bucket framework is a highly liquid component to meet nearterm living expenses for one year or more.

With money market yields close to zero currently, Bucket 1 is close to dead money, but the goal of this portfolio sleeve is to stabilize principal to meet income needs not covered by other income sources. To arrive at the amount of money to hold in Bucket 1, start by sketching out spending needs on an annual basis. Subtract from that amount any certain, nonportfolio sources of income such as Social Security or pension payments. The amount left over is the starting point for Bucket 1: That’s the amount of annual income Bucket 1 will need to supply.

More conservative investors will want to multiply that figure by 2 or more to determine their cash holdings. Alternatively, investors concerned about the opportunity cost of so much cash might consider building a two-part liquidity pool — one year’s worth of living expenses in true cash and one or more years’ worth of living expenses in a slightly higher-yielding alternative holding, such as a short-term bond fund. A retiree also might consider including an emergency fund within Bucket 1 to defray unanticipated expenses such as car repairs, additional health-care costs and so on.

Bucket 2

Under our framework, this portfolio segment contains five or more years’ worth of living expenses, with a goal of income production and stability. Thus, it’s dominated by high-quality bond exposure, though it might also include a small share of high-quality dividend-paying stocks and other yield-rich securities such as master limited partnerships. Balanced or conservative- and moderate-allocation funds would also be appropriate in this part of the portfolio.

Income distributions from this portion of

The bucket concept is anchored on the basic premise that assets needed to fund nearterm living expenses ought to remain in cash, dinky yields and all. the portfolio can be used to refill Bucket 1 as those assets are depleted. Why not simply spend the income proceeds directly and skip Bucket 1 altogether? Because most retirees desire a reasonably consistent income stream to help meet their income needs. If yields are low, the retiree can maintain a consistent standard of living by looking to other portfolio sources, such as rebalancing proceeds from Bucket 2 and 3, to refill Bucket 1.

Bucket 3

The longest-term portion of the portfolio, Bucket 3 is dominated by stocks and more volatile bond types such as junk bonds. Because this portion of the portfolio is likely to deliver the best long-term performance, it will require periodic trimming. By the same token, this portion of the portfolio will also have much greater loss potential than Bucket 1 and 2. Those portfolio components are in place to prevent the investor from tapping Bucket 3 when it’s in a slump, which would otherwise turn paper losses Morningstar into real ones.

As long as a retiree has both taxable and tax-advantaged assets like IRAs and company retirement plans, it’s usually best to hold on to the accounts with the most generous tax treatment while spending down less tax-efficient assets.

The following sequence will make sense for many retirees.

1) If you’re older than 70½, your first stop for withdrawals are those accounts that carry required minimum distributions, or RMDs, such as traditional IRAs and company retirement plans. (You’ll pay penalties if you don’t take these distributions on time.)

2) If you’re not required to take RMDs or you’ve taken your RMDs and still need cash, turn to your taxable assets.

Start by selling assets with the highest cost basis first and then move on to those assets where your cost basis is lower (and your tax hit is higher).

Relative to tax-deferred or tax-free assets, these assets have the highest costs associated with them while you own them. However, taxable assets could also be valuable to tap in your later retirement years because you’ll pay taxes on withdrawals at your capital gains rate, which is lower than your ordinary income tax rate.

3) Finally, tap company retirement-plan accounts and IRAs. Save Roth IRA assets for last.

For more on this topic, see: www.morningstar.com/now/ lifestage

RETIREES: Road Map

ven retirees who are seasoned investors will tell you that transitioning from accumulating to spending from their portfolios is a challenge. The “right” withdrawal rate and strategy seems to be a moving target.

Devising an asset allocation plan that balances safety and liquidity with longterm growth is no mean feat, either, especially given today’s high(ish) equity valuations and still low yields on bonds and cash. There are also psychological hurdles to jump over: After years of saving, transitioning into drawdown mode can feel a little bit scary.

Because mapping out a durable in-retirement investment plan can be so complicated, it’s crucial to do your homework. Above all, keep in mind that your in-retirement portfolio is a work in progress: The most successful retirement plans, while not overly complicated, need to change with the times and be responsive to changes in your own situation.

As you plot out your in-retirement financial and retirement plan, here are the key tasks to tackle.

Project and adjust your expenses

As you enter retirement, it’s valuable to compare your in-retirement budget with your ledger when you were working. If you were a heavy saver while in accumulation mode, taking savings off the table means that you’re apt to need a much smaller sum than you did while you were working. For this reason, Morningstar’s David Blanchett has found that higher-income workers’ income-replacement rates in retirement are much lower than their lower-income counterparts’. Of course, your spending may rise in other categories, such as travel and healthcare, but it may be offset through lower expenditures on categories such as work transport and eating lunches out.

A budget is as valuable in retirement as it is while you’re working and saving, but it requires some discipline and a bit of artfulness: Aim to strike the right balance between minding expenses and counting every penny.

Take stock of and maximize your sources of lifetime income

For most retirees, Social Security will be their key source of guaranteed lifetime in-

come; a small (and shrinking) share of the population will be able to rely on pensions that can be annuitized during retirement.

Obviously, the greater the certain sources of lifetime income that you’ll bring into retirement, the less you’ll need to tap your investment portfolio (and the better its odds of lasting). Ideally, those certain sources of income will cover your baseline living expenses—housing, food, utilities, and healthcare/insurance costs.

That underscores the virtue of maximizing those income sources.

Delaying Social Security, while not the right answer in every situation, is well worth considering. For every year that you’re able to delay past your full retirement age, you can pick up a roughly 8 percent increase in your benefits—an advantage that will be with you for the rest of your life. And if you have a pension, give due consideration to taking benefits as an annuity rather than a lump sum.

Don’t rule out some type of work

The complexion of “retirement” is changing before our very eyes. Thanks to improvements in healthcare, many retirees are healthier and more active than

their forebears. Moreover, many “retirees” aren’t fully retired at all, but instead continue to work in some fashion into retirement.

Working longer can be a win-win-win from a financial standpoint, reducing portfolio withdrawals and improving portfolio longevity, allowing for other financially beneficial decisions like delayed Social Security, and even enabling additional retirement-plan contributions later in life. Yet even as working longer is a worthwhile aspiration, the data show a disconnect between the percentage of pre-retirees who say they plan to continue working in some fashion through retirement and the percentage who actually do so. While a third of the workers in a 2014 Employee Benefits Research Institute survey said they planned to work past age 65, just 16 percent of retirees said they had retired post-age 65.

Health issues—for the older worker, spouse, or parents—and/or untenable physical demands of the job can derail a goal to work longer, for example. Thus, it’s crucial to ensure that “working longer” isn’t central to the viability Morningstar of your financial plan.

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The overarching idea is to set aside one to two years’ worth of living expenses in cash, while using additional buckets to hold more volatile assets with higher potential returns for the later years of retirement.

BUCKET PORTFOLIOS

T

FOR RETIRED INVESTORS

he Bucket Approach is a strategy for funding retirement cash-flow needs while also maintaining a diversified portfolio of stocks, bonds and cash. The overarching idea is to set aside one to two years’ worth of living expenses in cash (Bucket 1), while using additional buckets to hold more volatile assets with higher potential returns for the later years of retirement.

Morningstar has created a series of hypothetical portfolios that showcase how one might implement the bucket strategy. Each portfolio includes a cash component (Bucket 1), an intermediate-term component consisting mainly of bonds and balanced funds (Bucket 2) and a long-term component for growth, featuring stocks and higher-risk bond types (Bucket 3). The size of the buckets varies by time horizon. The portfolios are populated with funds that are favorites among Morningstar’s analysts.

Here we’ll share the series composed of traditional mutual funds — featuring aggressive, moderate, and conservative asset-allocation mixes.

Although the portfolios have only been around since late 2012, we conducted some performance tests to see how they would have withstood various market environments. Did they fund retirees’ cash-flow needs while also holding principal steady, or even growing it? The answer is yes. We stress-tested several scenarios and time periods — 2007-2012, 2000-2013, and varying implementation and rebalancing strategies — and found that the portfolios generally met their goals of providing in-retirement cash flow and growing principal.

Bucket basics

In each scenario — aggressive, moderate and conservative — we’re assuming a 4 percent withdrawal in year one of retirement, with that dollar amount adjusted upward to keep pace with inflation in subsequent years. Investors can, of course, apply their own starting withdrawal rates as needed; that will determine what percentage of their portfolios they hold in Bucket 1. As Bucket 1

AGGRESSIVE BUCKET

MODERATE BUCKET

CONSERVATIVE BUCKET

This portfolio is geared toward retirees with a time horizon (life expectancy) of 25 years or more and who have an ability to withstand the volatility that comes along with a 50 percent stock weighting.

This portfolio assumes a 20-year time horizon and less of an appetite for short-term volatility. It targets a weighting of 50 percent in stocks and 50 percent in bonds and cash.

This portfolio assumes a 15-year time horizon. It targets a weighting of 40 percent in stocks and 60 percent in bonds and cash.

Bucket 1: Years 1-2 8 percent: Cash (certificates of deposit, money market accounts, and so on) Bucket 2: Years 3-10 8 percent: Fidelity Short-Term Bond (FSHBX) 10 percent: Harbor Bond (HABDX) 4 percent: Vanguard Short-Term Inflation-Protected Securities Index (VTAPX) 10 percent: Vanguard Wellesley Income (VWINX) Bucket 3: Years 11 and Beyond 10 percent: Vanguard Total Stock Market Index (VTSAX) 24 percent: Vanguard Dividend Appreciation (VDADX)

Bucket 1: Years 1-2 10 percent: Cash (certificates of deposit, money market accounts, and so on) Bucket 2: Years 3-10 10 percent: Fidelity Short-Term Bond (FSHBX) 5 percent: Fidelity Floating Rate High Income (FFRHX) 15 percent: Harbor Bond (HABDX) 5 percent: Vanguard Short-Term Inflation-Protected Securities Index (VTAPX) 5 percent: Vanguard Wellesley Income (VWIAX) Bucket 3: Years 11 and Beyond 20 percent: Vanguard Dividend Appreciation (VDADX)

13 percent: Harbor International (HIINX)

10 percent: Vanguard Total Stock Market Index (VTSMX)

8 percent: Loomis Sayles Bond (LSBRX)

10 percent: Harbor International (HIINX)

5 percent: Harbor Commodity Real Return (HACMX)

5 percent: Harbor Commodity Real Return (HACMX)

Bucket 1: Years 1-2 12 percent: Cash (certificates of deposit, money market accounts, and so on) Bucket 2: Years 3-10 12 percent: Fidelity Short-Term Bond (FSHBX) 5 percent: Fidelity Floating Rate High Income (FFRHX) 20 percent: Harbor Bond (HABDX) 6 percent: Vanguard Short-Term Inflation-Protected Bond Index (VTAPX) 5 percent: Vanguard Wellesley Income (VWIAX) Bucket 3: Years 11 and Beyond 23 percent: Vanguard Dividend Appreciation (VDADX) 7 percent: Harbor International (HIINX) 5 percent: Harbor Commodity Real Return (HACMX) 5 percent: Loomis Sayles Bond (LSBRX)

5 percent: Loomis Sayles Bond (LSBRX) is depleted to meet living expenses, the retiree would refill it using income and dividend distributions and/or rebalancing proceeds.

In all instances, Bucket 1 is designed to cover living expenses in years one and two of retirement. Its goal is stability of principal with modest income production. Risk-averse investors who want an explicit guarantee of principal stability will want to stick with FDIC-insured products for this sleeve of the portfolio.

On the flip side, investors comfortable with slight fluctuations in their principal values may steer less than a year’s worth of living expenses to true cash instruments.

Bucket 2 is next in line to supply living expenses once Bucket 1 has been depleted. The goal for Bucket 2 is stability and inflation protection as well as income and a modest amount of capital growth. In all instances, Bucket 2 is an-

chored by two sturdy, flexible core bond funds: one short-term and the other intermediate. In addition, it includes exposure to inflation-protected securities and a hybrid stock/bond fund (Vanguard Wellesley Income) to provide income with a shot of stock exposure. And in the Moderate and Conservative portfolios, we’ve added a small stake in a bank-loan (or floating-rate) fund, Fidelity Floating Rate High Income, which will tend to have limited interest-rate sensitivity and might also offer a measure of inflation protection. (Note that the Aggressive portfolio doesn’t include the bank-loan fund; because the Aggressive portfolio’s bond stake is smaller than the other two portfolios’, it sticks with plain-vanilla bond funds.)

Because Bucket 3 will remain untouched for the next decade, the assets here are primarily invested in equities, with smaller stakes in high-risk bonds

(Loomis Sayles Bond) and commodities for inflation protection. This bucket is the growth engine of the portfolios, but note that the core stock holding — Vanguard Dividend Appreciation — focuses on high-quality names and tends to offer better downside protection than many large-cap stock funds. The Aggressive and Moderate portfolios also include positions in a total stock market index fund to provide exposure to sectors that Vanguard Dividend Growth is light on, such as technology; the Conservative portfolio omits that position because its stock stake is smaller overall. This portion of the portfolios also includes exposure to foreign stocks, which have the potential to add to the portfolio’s volatility level in part because of currency fluctuations. Risk-conscious investors might therefore consider scaling back the foreign-stock portion of the Morningstar portfolio.

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RETIREES

At a high level ... delayed claiming is something most people should think about — especially married couples — because ... one person in the couple is likely to exceed the longevity numbers, and that’s where Social Security provides a huge benefit.

ERT S EXPG T INSI H

HOW TO MAKE

MONEY LAST IN RETIREMENT

W

e’re living longer.

And even if we’ve saved for our retirement, will we have enough? When should we file for Social Security benefits? And how much should we be taking out of our retirement portfolios each year? A recent panel at the Morningstar Individual Investment Conference tackled these questions and more. Panelists included Morningstar’s Christine Benz, financial planner Mark Balasa, of Balasa Dinverno Foltz, and retirement specialist Mark Miller. Here’s an edited excerpt of the conversation: Morningstar: Mark, when you have a client who comes to you and says, “I’m thinking about retiring; I’m not sure if I have enough,” how does longevity enter into the discussion?

Mark Balasa: Let’s say you’re 65; your life expectancy is usually in your early 80s. Fidelity and J.P. Morgan have done some nice work showing that a married couple, if they are 65 at the moment, has a 90 percent chance of one of them making it to 80, a 70 percent chance of making it to 85, and a 50 percent chance of making it to 90.

So we try to help them better understand that, as a couple, someone is going to be here probably longer. We need to be really conservative when we are running projections — should it be around 85, 90 or 95? We help to encourage them to think about longevity in those terms.

Christine Benz: You also want to factor in your own health history, familial health history, your parents’ longevity and your grandparents’ longevity. If your family has a history of longevity, you also want to think about the role of cognitive decline because we also tend to see a strong correlation between longevity and a higher prevalence of cognitive decline.

An NIH study found that roughly 25 percent of people in their 80s were experiencing some sort of cognitive decline or dementia, and that number jumps even higher if you are in your 90s.

The combination of that greater longevity and potentially the need for longterm care would argue for a larger pool of money that you would need to set aside for your own retirement.

Morningstar: A lot of people talk about working longer into their retirement years. Mark, you have written about employment prospects for older workers.

How realistic is that expectation?

Mark Miller: It’s a great aspiration, and it’s a good idea to work a few additional years. Even working an extra three

to five years is very salutary for your retirement plan in terms of additional years of contributing to retirement accounts, fewer years of drawing down from that money in large sums and then the opportunity to delay your Social Security claiming. Together, those things can have a very dramatic impact on your retirement plan.

There is also, however, an acknowledgment that there is a lot of age discrimination in the workforce. The numbers also tell us that roughly half of people retire earlier than they expected because of a health problem or because they are providing care for somebody else, job loss or job burnout. So, I think

really is a great starting point. You absolutely need equities for the longevity risk. You need that growth portion of your portfolio. When you think about the fact that starting bond yields have historically been a pretty good predictor of what you might expect from bonds over the next decade, well, at 2 percent on the Barclays U.S. Aggregate Bond Index right now, that’s not a return engine for many retirees. They’ll be lucky to keep up with inflation at that level. So, you absolutely do need stocks in the portfolio.

In talking to retirees recently and hearing from readers, though, my concern is that there is some complacency about equity-market risk — that, in fact, re-

The combination of that greater longevity and potentially the need for long-term care would argue for a larger pool of money that you would need to set aside for your own retirement. working longer is a great strategy, and it is a great thing to try to do. It is not a plan, though.

Morningstar: For many, Social Security will be the only guaranteed lifetime income source. Can you provide some sort of basic rules of thumb or guidelines in terms of how to best treat that benefit?

Miller: At a high level, I think delayed claiming is something most people should think about — especially married couples — because, as has just been pointed out, one person in the couple is likely to exceed the longevity numbers, and that’s where Social Security provides a huge benefit. Oftentimes, you have situations where people get into their late 80s or 90s, and they’ve exhausted their savings, and then Social Security is still there as a bedrock.

Morningstar: If you are trying to build a portfolio that’s going to last for a 25- or 30-year retirement or longer, what are the basic components that you need to focus on?

Benz: I think a balanced portfolio

tirees are perhaps too comfortable with their equities. They have forgotten what it felt like during the bear market. So, if anything, I think many retirees seem to be erring on the side of having too much equity risk in their portfolios. You absolutely do need stabilizers, and that’s why my hypothetical retirement bucket portfolios include cash, they include high-quality bonds — miserly yields and all. But the idea is that those are the ballast for the return-engine piece of your portfolio.

Morningstar: How should people think about health care spending in retirement?

Miller: I would start with Medicare because most of us are going to file for it at age 65. Medicare does a good job of smoothing out the more general, routine health-care costs and some not-so-routine costs as well. If you need to go into the hospital, it covers a great deal of that.

The basic decision is whether you want traditional Medicare or the managed-care version, which is called Medicare Advantage. It can save some money for some people, but I still regard

traditional Medicare as the gold standard because it gives you the greatest flexibility in terms of seeing providers. It costs a bit more, and it requires more paperwork because you’re putting together the different layers on your own. There are more moving parts. But for a lot of people it’s the way to go because they don’t want to worry about just seeing in-network doctors.

Morningstar: Mark, is long-termcare insurance something that you recommend for your clients?

Balasa: In many cases, our typical client can self-insure because they have sufficient assets. The typical monthly cost of long-term care in today’s dollars is somewhere between $8,000 and $10,000. We then use a conservative average stay of around four to five years. We’ll put that into their plan, inflate it and see whether the client can withstand that.

Some clients still like insurance because of the psychology around it.

They’ve seen how their own families have been devastated by end-of-life costs, and so they might buy just a starter policy, even though they don’t really need it.

Miller: There have been massive price increases with long-term care policies because the underwriters have had trouble figuring out how to properly price these things. Some people think we’re through the worst of that, but the increases have been scary. For people who have seen increases of 40 percent, it usually makes sense to hang on and ride through it, because you’ve already invested in the policy.

Morningstar: Some people like the lifetime income stream that annuities offer.

Others talk about the high cost and wonder if it’s worth it. Are there specific kinds of annuities that you would recommend?

Benz: I would tend to start with a very plain-vanilla annuity type. The problem is, interest rates are really low. Annuity payouts from the single premium immediate annuities are arguably as low as they can go, too. I think it might be an interesting product for someone who wants to just add that baseline of assured income, but the timing issue is certainly there.

Balasa: You can make a scenario for annuities, but a lot of times, the cost is an issue, and also the quality of the insurance company backing the annuity.

And then, of course, the big concern is people losing the assets at death. There are different payout options for survivors, but when you factor in that the money doesn’t pass on to the family, that’s for many families a Morningstar showstopper.

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WORKING

PAST 65

THREE WAYS TO MAKE IT LESS OF A CHORE

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ou’ve run the calculations. You’ve kicked up your savings rate, opened Roth accounts, maxed out 401(k)s, and tweaked your asset allocation to allow for more longterm growth. And despite all of your efforts, you’re faced with a bleak scenario: You’re going to have to work longer than you had originally hoped.

It might be small consolation, but you’re far from alone. Most people hurtling into retirement today won’t have the financial safety net of a pension. Yet they haven’t amassed enough of their own financial assets to cover their expenses once they retire.

They have only one option left: working longer, provided they’re able to do so.

Even if you don’t absolutely have to work past 65, numerous studies and retirement calculators clearly illustrate the benefits of continuing to do so. Not only will you continue to collect your paycheck, but you’ll also reduce the number of years you’ll have to rely on your nest egg, thereby improving the odds it won’t run out prematurely. Delaying Social Security past your normal retirement age also means that you’ll receive a

higher payout from the program.

If you fall into the “work longer” contingent, the thought of setting your alarm for 6 a.m. and packing sack lunches past age 65 might seem downright unappealing. Aren’t you supposed to be spending your post65 years spoiling your grandkids and seeing the sights you didn’t have time to see when you were still working?

Maybe. But if you’re still healthy and have a job, those are two pluses right there. And there are ways to make working longer more palatable, three of which we’ve shared below. The unifying theme among all of them is to relax and begin enjoying a happier lifestyle even as you continue to collect a paycheck.

Stop saving

One idea for enjoying the fruits of your labors even as you continue to work comes courtesy of T. Rowe Price. The investment firm found that working longer greatly increased a person’s chances of not outliving his nest egg as a result of three factors: continued income, delayed portfolio withdrawals and a larger Social Security check. At the same time, T. Rowe found that the advantages of saving within tax-deferred accounts like a 401(k) aren’t

especially great for late-career savers. Yes, your money will compound tax-deferred, but the benefits of tax-deferred compounding on new investments aren’t nearly as great as they were earlier in your career. Given that data set, T. Rowe asserts that a healthy compromise for many pre-retirees is to continue working but begin spending some of that cash that they had previously been earmarking for their 401(k)s. T. Rowe Price calls it “Practice Retirement.”

Start Social Security for one spouse

Two-career couples know how much easier life is on days when one of them is off. No one has to squeeze in walking the dog before work or come home to a dark house. And errands that we normally tackle on the weekends are magically completed.

If both you and your spouse are still working, one option to improve both partners’ quality of life is for one spouse to stop working while the other one stays on the job.

Assuming the lower-earning spouse is the first to retire, he or she could begin claiming benefits based on his or her own work record at age 62, while the higher-earning spouse delays benefits until age 70.

(This strategy is sometimes referred to as the 62/70 split.) The Social Security Administration’s website has some extremely useful tools for modeling out various scenarios.

(You also can call the Social Security administration or visit a local office if you have specific questions about your own situation.)

Make it a labor of love

If you’ve logged a long career within a specific field or with one company, staying put for the rest of your working years might deliver the highest financial payout.

However, needing to work longer doesn’t necessarily mean you have to do the same job you’ve always done, and staying put in a job you hate may exact a mental and physical toll even while it improves your financial well-being. Morningstar contributor Mark Miller has written extensively about encore careers — those embarked upon after age 50 that tap into a pre-retiree’s desire to do a job that offers personal meaning and gratification.

Such positions may not offer the same financial rewards that your old 9-to-5 job did, but if you’re doing something you love, the trade-off might be Morningstar worth it.

RETIREES, ARE YOU SPENDING TOO MUCH?

H

ow much can you spend in retirement without outliving your money? It’s one of the most fundamental questions confronting anyone who’ has retired — or is getting ready to.

But it’s a head-scratcher for many, according to a survey from the American College of Financial Services. Seven in 10 individuals between the ages of 60 and 75 with at least $100,000 said they were unfamiliar with the oft-cited 4 percent withdrawal-rate guideline. Meanwhile, 16 percent of survey respondents pegged 6 percent to 8 percent as a safe withdrawal rate.

That’s a problem. Because setting a sustainable withdrawal rate is such an important part of retirement planning, pre-retirees and retirees who need guidance should seek the help of a financial advisor for this part of the planning process.

And at a bare minimum, anyone embarking on retirement should understand the basics of spending rates: how to calculate them; how to make sure their spending passes the sniff test of sustainability given their time horizon and asset allocation; and why it can be valuable to adjust spending rates over time.

How to calculate spending rates

To determine your own spending rate, simply tally up your expenses — either real or projected — in a given year. Subtract from that amount any nonportfolio income that you’re receiving in retirement: Social Security, pension, rental or annuity income, to name a few key examples. The amount that you’re left

with is the amount of income you’ll need to draw from your portfolio. Divide that dollar amount by your total portfolio value to arrive at your spending rate.

Say, for example, a retiree has $60,000 in annual income needs, $28,000 of which is coming from Social Security and the remainder of which — $32,000 — she will need to draw from her portfolio. If she has an $800,000 portfolio, her $32,000 annual portfolio spending is precisely 4 percent. But if she needs to draw $50,000 from her portfolio, her spending rate is 6.25 percent.

The 4 percent rule, unpacked

The notion that 4 percent is generally a safe withdrawal rate was originally advanced by financial planner William Bengen. It has subsequently been refined — but generally corroborated — by several academic studies, including the so-called Trinity study. Before retirees take the 4 percent guideline and run with it, however, it’s important to understand the assumptions that underpinned it.

First, the research assumed that retirees would wish to maintain a consistent standard of living, drawing a steady stream of income from their portfolios each year. Thus, the 4 percent guideline assumes that the retiree spends 4 percent of his or her initial balance in year one of retirement, then subsequently nudges the amount up in subsequent years to keep pace with inflation. He or she doesn’t take 4 percent of the balance year in and year out, though that’s a viable spending-rate method, too.

Additionally, the 4 percent guideline

assumes a 60 percent equity/40 percent bond asset allocation and a 30-year time horizon, and that the 4 percent, whether it comes from income and dividend distributions or from selling securities, is the total withdrawal. Thus, a retiree whose portfolio was generating 4 percent in income distributions couldn’t take an additional 4 percent from her principal.

Swing factors

Because not every retiree’s profile matches those parameters, not every retiree should take the 4 percent guideline and run with it. Retirees should be prepared to adjust their spending rates up or down based on the following factors: Time horizon: Retirees with time horizons that are longer than 30 years should plan to take well less than 4 percent of their portfolios in year one of retirement. On the flip side, older retirees — those 75 or older, for example — might consider taking a higher withdrawal rate. David Blanchett, head of retirement research for Morningstar Investment Management, has suggested that retirees consider their life expectancies when determining their spending rates. The IRS’ tables for required minimum distributions from IRAs can help you see the interplay between life expectancy and withdrawal rates.

Asset allocation: A retiree’s asset allocation also should be in the mix when calibrating sustainable spending rates. The 4 percent guideline, as noted above, is centered around a 60 percent equity/40 percent bond mix. But investors who want to employ a portfolio that

includes more bonds and cash should be more conservative in their spending rates, notes Blanchett. The reason is that bond yields have historically been a reasonable predictor of bond performance in subsequent years, and bond payouts are ultralow right now.

Market performance: The bear market of 2008 illustrated so-called sequencing risk: Retirees greatly reduce their portfolios’ sustainability potential when they encounter a lousy market early on in their retirements and don’t take steps to reduce their spending. That’s because if they overspend during those lean years, they leave less of their portfolios in place to recover when the market does.

Right spending strategy for you

Indeed, much of the recent research on sustainable withdrawal rates supports the idea of tying in withdrawal rates with portfolio performance. The retiree takes less out in down-market years and can potentially take more out in years when the market performs well.

The purest way to tie in spending with portfolio performance is simply to take a fixed percentage of that portfolio — say, 4 percent — year in and year out.

Under this method, the retiree could take $32,000 from his or her portfolio when its value is $800,000, but would be forced to live on $24,000 if his or her portfolio dropped to $600,000 in value.

Using the fixed-percentage method, the retiree would never run out of money, but he or she might not be able to make do on the smaller Morningstar amount.

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RETIREMENT PLANNING

HOW TO GROW YOUR

401k What makes a good plan – and when you should lobby for change?

Y

BY CHRISTINE BENZ

our company retirement plan may well be getting better. The introduction of “nudge” features like automatic enrollment and auto-escalation (participants put more into their 401(k)s when they get raises) and the uptake of professional management mean that many 401(k) investors are able to save more and invest better than they would have even a decade ago. Morningstar also is seeing more and more index funds in 401(k) plans, which usually feature ultra-low costs.

But there still are huge variations in plan quality across employers.

Although plans from large employers aren’t universally good, scale is generally an advantage in the 401(k) marketplace. That means that a plan that contains many millions of dollars is going to have more clout to swing a good deal with providers than will the plan of a tiny firm that lacks a big 401(k) kitty. Moreover, smaller firms, by necessity, frequently require employees to multitask: At a smaller firm, the person who’s charged with maintaining the 401(k) plan on an ongoing basis may also be overseeing payroll and selecting phone plans.

If you suspect your plan is lacking, don’t just commiserate with colleagues about it. By doing a thorough checkup of the plan, you can decide how much of your investment dollars to allocate toward it; you may decide to invest just enough to earn matching contributions and then turn to an IRA with any additional contributions. Checking up on your plan — and taking the extra step of documenting what you find and communicating it to your 401(k) committee or the individual who oversees your

MAKING THE MOST OF A HEALTH SAVINGS ACCOUNT ONCE YOU TURN 65

BY KIMBERLY LANKFORD KIPLINGER’S PERSONAL FINANCE

Q: Does the penalty for using health savings account money for non-medical expenses disappear entirely at age 65? Does that mean I could withdraw the money after age 65 for a vacation and just pay taxes on the money, like I would with a 401(k)?

A: Yes to both questions. You’ll have to pay a 20 percent penalty plus income taxes if you withdraw money from an HSA for non-qualified expenses before age 65. But the penalty disappears at 65, and you’ll just have to pay taxes on the withdrawal if you use the money for anything other than eligible medical expenses at that point — similar to the tax deferral of a 401(k).

But you may be able to do even better. After age 65, you can use HSA firm’s benefits package — can also help you build a case for improving it.

A basic audit

You may have noticed that your company retirement plan is lacking a good core bond fund, or your gripe is that matching contributions are low. But before sounding off on these problems on a one-off basis, take stock of the plan from top to bottom, including a review of its administrative costs, fund choices and their expenses, employer matching contributions, and the presence of additional options, such as the ability to make Roth and after-tax contributions.

Note that this review process generally applies to 403(b)s and 457s, too.

money tax-free for several extra expenses, such as paying your monthly premiums for Medicare Part B and Part D and Medicare Advantage plans.

If you have your Medicare premiums paid automatically from your Social Security benefits, you can withdraw the money tax-free from the HSA to reimburse yourself for those expenses. And you can continue to use HSA money tax-free to pay your outof-pocket costs for medical care and prescription drugs, dental and vision care, a portion of long-term-care insurance premiums based on your age (up to $4,220 in 2019 for people ages 61 through 70, for example) and other eligible expenses. For more information about HSA-eligible expenses, see IRS Publication 969, Health Savings Accounts.

Plus, there’s an interesting nuance

Unfortunately, you won’t be able to find every bit of information you need in a single document; you’ll need to gather the information from various sources, including your plan’s Summary Plan Description and annual report (Form 5500), both of which you can obtain from your company. Here are the key items to look for, as well as how you’ll find them and how you can benchmark them.

Matching contributions

Find the amount of your contributions that you’re being matched on in the Summary Plan Description. Also, check up on the vesting schedule for those matching contributions (how long you’ll need to stay at the company

to the law that lets you withdraw money tax-free from an HSA to recoup payments for any eligible medical expenses incurred since you opened the HSA, even if the reimbursement is years in the future. That means if you paid cash for any eligible medical expenses after you established your HSA, rather than tapping the account, you can let the money grow tax-deferred in the HSA and then withdraw it taxfree at any time to recoup your costs.

“It’s important for consumers to keep their receipts for their qualified HSA expenses,” says Steve Auerbach, CEO of Alegeus, which provides technology for HSAs. Many health plans and HSA administrators provide web tools to help you track your bills for qualified medical expenses and note how you paid those bills. to be able to take those contributions with you when you leave). Armed with that information, you can assess whether your employer’s matching setup is generous, miserly or somewhere in-between. The most common matching configuration is 50 percent of contributions, up to 6 percent of pay. Of course, you always want to invest enough to earn matching contributions, but if upon further research you determine your plan is subpar, you may want to steer additional retirement contributions elsewhere.

Administrative fees

This is the trickiest part of any 401(k) assessment. That’s because plans can charge administrative

TIP: CAREFULLY CONSOLIDATE

BY MARY KANE KIPLINGER’S PERSONAL FINANCE, YOUR MONEY

I

f you’ve worked for multiple companies in your lifetime, you probably have accumulated several 401(k) accounts, a couple of IRAs and a brokerage account or two.

As you near retirement, you might consider consolidating some of the accounts to help you organize and track your investments and perhaps save some money with fewer account fees.

Consolidating your employer plans in one IRA “retains the tax-advantaged status of the assets, allows more choice of investments and ensures you remain in touch with your assets,” says Terry Dunne, senior vice president at Millennium Trust Co. But while consolidation may result in “simplification and convenience,” it’s not as easy as it sounds, says Ajay Kaisth, a certified financial planner in Princeton

Junction, N.J. And there are some good reasons for maintaining separate accounts, so you “need to be sure that the benefits outweigh the costs,” he says.

You might, for instance, want to keep a 401(k) plan that has lower-cost institutional shares of mutual funds and access to commission-free trading, instead of rolling it into an account without those features. Or, if you want to make a qualified charitable distribution someday, you can only do that through an IRA. Before you make any moves, review the rollover chart at IRS.gov to learn which accounts can be rolled over into another. Study the specific rules of each of your plans; custodians can vary in whether rollovers are allowed and what kind of fees are involved, says Joyce Streithorst, a CFP in Melville, N.Y. Next, weigh the pros and cons of consolidating. Combining accounts makes it easier to manage your money and “to

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MARCH 2019

21

RETIREMENT PLANNING

EX INSIPGEHRT TS

401K INVESTMENT

MISTAKES TO AVOID

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company retirement plan — whether a 401(k), 403(b) or 457 plan — is the starter savings vehicle for many investors, so it’s probably not surprising that the plans usually have more guardrails than other investment vehicles.

Company-retirement plan menus typically feature plain vanilla stock and bond funds to keep plan participants from gorging on exotic investment choices and participants are often opted into age-appropriate target-date fund vehicles. And because 401(k) participants are often hands-off, many plans offer features such as automatic escalation to increase contributions as participants’ salaries grow.

Yet, not all plans include such safety features, and 401(k) menus aren’t universally high quality.

In short, 401(k) plans invite the potential for plenty of goofs. Here are common ones, as well as tips on avoiding those mistakes.

PLAN fees in a number of ways. The employer can pay administrative costs itself, or it can pass them on to plan participants. If the latter, the administrative costs may be deducted directly from plan assets, or they might be embedded in the individual-fund fees. Those varying fee setups mean that there’s no single location for the information.

But a starting point is your plan’s annual report (Form 5500). In it, you may see your plan’s administrative expenses expressed as a dollar amount. You’ll then need to divide that dollar amount by the total assets in the plan to arrive at a percentage.

BrightScope.com also provides some comparative information on 401(k) plan expenses. There aren’t hard-and-fast cutoffs about what constitutes a high-cost plan, and administrative-expense percentages will tend to vary based on employer size. In general, however, if your plan’s administrative costs edge above 0.5 percent — and certainly if they’re more than 1 percent — that’s a red flag that you have a high-cost plan. After all, those expenses come on top of whatever the underlying investments charge.

that may be by design — but it’s fair to ask to be able to build a plain-vanilla stock/bond portfolio within the confines of the 401(k).

Investment lineup breadth

Additional features

Does your plan offer the basic portfolio building blocks for workers at various life stages, including well-diversified U.S. stock, foreign-stock and core bond funds?

Does it include target-date funds for investors who don’t want to handle asset allocation? Many 401(k) plans fall short on the bond side, offering just a single government-bond fund, for example. It’s not cause for concern if your lineup doesn’t offer exposure to each and every small asset class — in fact,

Quality of investment lineup

In addition to checking up on the breadth of your 401(k) lineup, you should also assess the quality of the offerings. Morningstar.com offers an abundance of information on this front, including fee comparisons for individual funds relative to appropriate peer groups; but be sure that you’re matching the share class in your plan to the appropriate share class on the site.

(For a given fund, click the “Expense” tab on its main page to see more details about its expenses.)

Also, pay attention to what share classes you can buy: Does your plan hold higher-cost share classes when cheaper ones are available?

(The cheaper share classes may not be available to your particular plan, but it’s worth asking.)

Not every fund option must have ultra-low expenses and earn a Morningstar Analyst Rating of Gold (or any medalist rating at all), but document funds that have low ratings and/or above-average expenses.

While the quality of the investment lineup is key to making an assessment of it, also take stock of additional features. Does it include additional useful features, such as automatic rebalancing and automatic escalation? Does it include a Roth 401(k) option or the ability to make after-tax contributions? A lack of such features shouldn’t be a deal breaker, but if you value any of them, be sure to tell the individual(s) overseeing Morningstar your 401(k) plan.

RETIREMENT ACCOUNTS see the big picture,” Streithorst says.

Fewer accounts mean fewer monthly or quarterly statements and possibly lower costs.

Consolidating also makes it easier to calculate and take required minimum distributions after age 70 1/2, Kaisth says. For each 401(k) you own, you must take a separate RMD. But if you consolidate old 401(k)s into one rollover IRA, you can take a single distribution.

But there are some drawbacks, and many of them affect early retirees, who might lose options to access money penalty-free if accounts are consolidated. For instance, if you leave your job at age 55 and your 401(k) allows partial withdrawals, you’d want to keep that account separate, says Tiffany Beard, a CFP in Jacksonville, Fla. This would allow you to take out money before age 59½ without paying the 10 percent penalty for early withdrawals that you would usually face if you

rolled the 401(k) into an IRA. You can still take penalty-free withdrawals from an IRA if you’re younger than 59½, although it may take a few financial steps. This involves using the 72(t) strategy, in which you withdraw the money in substantially equal periodic payments, Beard says. Say you have $1 million in your IRA but you don’t want to take distributions based on that large balance. You could split off $500,000 into a separate IRA and take withdrawals penalty-free using the 72(t) rules on the new, smaller IRA. Once you finish the distributions from that IRA, you’d still have the other IRA to use later in life.

Mary Kane is an associate editor at Kiplinger’s Personal Finance magazine.

Send your questions and comments to moneypower@kiplinger.com. And for more on this and similar money topics, visit Kiplinger.com.

1.

Not considering asset allocation before making investment choices When making investment selections, 401(k) participants are typically confronted with a menu of individual fund choices. The importance of setting an age- and situation-appropriate stock/ bond mix never even comes up, even though that will be the biggest determinant of how the portfolio behaves.

Setting an appropriate asset allocation is more art than science; refer to “Finding the Right Stock/Bond Mix” on Page 7 for tips on setting your own.

2.

Not investing differently if your situation is an outlier Target-date funds often are the default options in 401(k) plans, and they’re valuable in that they can help investors set their asset allocations and monitor them on an ongoing basis. Even investors who don’t intend to invest in a target-date fund can use them to help determine an age-appropriate investment mix.

That said, the allocations embedded in target-date funds won’t be right for everyone, especially for people with substantial assets outside their 401(k) plans.

For example, individuals who will be able to rely on pensions to cover most of their in-retirement expenses will likely want a more aggressive asset allocation than would be the case for generic target-date funds. (For this reason, some employers use custom target-date funds, tailored to the situations of their plan participants.)

stocks and exchange-traded funds. The big downside, however, is that participants will typically incur transaction costs to buy and sell securities within the brokerage window. Those trading costs can drag on returns, especially for investors who are making frequent small purchases.

6.

Avoiding no-name funds Company-retirement-plan menus are often populated with funds from the big shops — Vanguard, Fidelity, T. Rowe Price, and American Funds.

But plans also may include less-familiar names, often collective investment trusts that are explicitly managed for retirement plans. Although information may be less widely available on some of these options than is the case for conventional mutual funds, their expenses may be low and their quality may be good.

7.

Overdosing on company stock In 2014, the average 401(k) plan participant has more than 7 percent of his or her portfolio in stock of the employer, according to information from the Investment Company Institute. That’s not a scary number in and of itself, but many participants obviously have much higher stakes and some have none. Even if an employer doesn’t run into Enron-style problems, employees with a lot of company stock have too much of their economic wherewithal riding on their employer’s performance: their own jobs, plus their portfolio’s performance as well. As Morningstar research has indicated, most investors are better off limiting their positions in company stock, though there may be a few mitigating situations in which to hang on to it.

8.

Not taking full advantage of the tax-advantaged wrapper One of the big advantages of a 401(k) plan is tax-deferred compounding: Even if an investment is kicking off heavy income or capital gains distributions, the 401(k) investor won’t owe any taxes until he or she begins pulling money from the plan.

For that reason, it’s wise to stash those investments with heavy year-to-year tax costs inside a 401(k) or IRA. That includes funds that invest in high-yield bonds and Treasury Inflation-Protected Securities, REITs, and high-turnover equity funds.

That said, investors needn’t go out of their way to add high-tax-cost investments if they don’t make sense for them from an investment standpoint. Most young investors have little need for bonds within their 401(k) plans, for example.

3.

9.

4.

10.

Not factoring in other assets when making investment selections For investors who have been working and investing for a while — or those with spouses who hold their own investment accounts — their 401(k) plans may be but a small piece of their overall assets.

In that case, it’s wise to factor in all of the retirement assets when determining how to allocate the 401(k). Morningstar. com’s X-Ray function (morningstar.com) can help investors see the composition of their total portfolios across accounts.

They can then use their 401(k) plan assets to help steer the total portfolio toward their desired asset-allocation mix.

Focusing too much on past returns when making investment choices In addition to not getting much coaching on their asset allocations, many 401(k) participants are given a limited amount of information about the investment choices on their plans’ menus. They may see a fund’s asset class or category, as well as its returns over a certain time period, such as the past five years. Is it any wonder so many novice investors simply reach for the funds with the highest numbers? Of course, that’s not a recipe for great investment results, as those high performers often fall back to Earth. Rather than chasing the hottest performers, investors are better off focusing on fundamental information about funds’ strategies, management, and expenses to help populate their asset-allocation mixes. Morningstar’s qualitative Analyst Ratings, available on Morningstar.com, attempt to pull all of these considerations together into a single forward-looking measure.

5.

Venturing into the brokerage window without paying attention to transaction costs If investors do their homework on the fund options on their 401(k) menu and find them wanting, the ability to invest via a brokerage window might appear to be a godsend. Such windows typically give participants many more choices than they have on the preset menu, including the ability to invest in individual

Trading too frequently The tax-deferred nature of a 401(k) — combined with the fact that 401(k) investors don’t typically incur sales charges to buy and sell shares of funds on the plan’s preset menu — can be an invitation to trade frequently or to employ tactical, market-timing strategies. But Morningstar Investor Returns data casts doubt on whether investors can add value with frequent trading; investors in target-date funds, a type of allocation fund, because they often buy and then sit tight, often garner better outcomes than investors venturing into and out of individual categories.

Sticking with default contribution rate In the interest of encouraging more employees to participate, many employers now are automatically enrolling their employees in the 401(k). The early results of these efforts show that many employees who are automatically enrolled do, in fact, stick with the plan — a positive outcome. However, employees who stick with the default contribution rate after they’ve been automatically enrolled — the average is 3.4 percent — may not earn their full employer matching contribution, if it’s a generous one.

Moreover, a 3.4 percent savings rate — assuming the employee isn’t also saving outside the 401(k) plan and/or doesn’t have a very high salary — is far below any reasonable retirement-savings target.

11.

Not taking advantage of other automatic features In recognition of the fact that initial default contribution rates may be insufficient, some plans also opt their employees into auto-escalation, nudging up their contributions as the years go by. For other plans, automatic escalation is voluntary. Taking advantage of this option can be a painless way for employees to save more of their salaries, particularly if their contributions increase at the same time they receive raises. Automatic rebalancing also can help hands-off investors by regularly restoring their portfolios back to their target-alloMorningstar cation mixes.

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ERT S EXPG T INSI H

3 SIMPLE WAYS TO BUMP UP YOUR SAVINGS RATE

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nvestors often obsess about which funds to invest in, or whether they should open a Roth IRA or a traditional IRA. But what investors really should be obsessing about is how much they are saving each month.

By far the most impactful thing you can do to improve your chances of reaching your retirement goals is bumping up your savings rate.

Morningstar.com site editor Jason Stipp recently discussed strategies for increasing your savings rate with director of personal finance Christine Benz: Jason Stipp: You often hear that every little bit counts when you’re saving for retirement. Can you give us an example of how saving just a little bit more can actually have a big impact if you have a long time before you retire?

Christine Benz: If you have compounding on your side, you can make those small sums work very hard for you. For example, if you are a 21-yearold, and you’re able to save $100 a month, and you earn just 5 percent on your money, and you save all the way until retirement, you’d have about $200,000 when you turn 65.

If you are someone who is able to kick in $50 more per month — $150 in total — you’d have $300,000 by age 65. So those small amounts, if you can find them in your budget, can really be quite impactful, especially when stretched out over a long time horizon.

Stipp: We’re talking about some ideas for bumping up your savings rate. The first one is a chunk of money that most folks get around April each year, which is their tax refund.

Benz: That’s right. Roughly eight in 10 people get some kind of a tax

refund. The size of the average refund is about $2,800, but that number is skewed by some high-income taxpayers who receive very large refunds. When you look at refunds for folks in the lowest income tax bracket, the average refund isn’t anything to sneeze at. It’s about $2,000. So, when you think about investing that sum of money, especially if you have a long time horizon and can let the money grow, say, over a 40- or 45-year period, you can turn that refund into a pretty nice chunk of change.

Stipp: The refund is, in some ways, forced savings. After all, that tax refund money is essentially yours, but the government is kind of saving it for you.

Benz: That’s right. When you look strictly at the numbers, you see that really you should not be giving the government this interest-free loan throughout the year. But for a lot of

people, it is like an enforced savings plan.

The nice thing about refund season is that it also coincides with IRA season. You have until April 15 to fund your IRA for the prior tax year. So try to tie those two things together: Steer at least a portion of your tax refund into an IRA at the same time.

That can be a great way to tick up your savings rate.

Stipp: And if you’re lucky enough to be getting a raise or bonus this year, before you go out and spend that or increase your standard of living, maybe think about saving at least part of it.

Benz: We’ve come through a period of wage stagnation for a lot of workers. We’re starting to see some indications that that may be changing, that more people may in fact be in line for raises this year. That’s great news. If you’re lucky enough to have received a raise recently, think about steering

CREATING A SUCCESSION PLAN FOR YO

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BY CHRISTINE BENZ

n a presentation I often give to retired investors, I discuss the key ingredients for successful retirement portfolios. As I talk, I can see attendees mentally sizing up whether their own portfolio plans contain the components that I’m discussing. Stocks for longevity potential? Yes. Inflation protection to help preserve the portfolio’s purchasing power? Check. A cash component for near-term living expenses? Got it.

But one ingredient invariably piques their attention more than the others, perhaps because many never give it much more than a nervous thought: a succession plan for their portfolios.

Most of these investors have put together savvy investment programs, and many of them have crafted costly estate plans with the help of attorneys.

But as do-it-yourself investors, they have no clear road map for what should happen to their portfolios if they become incapacitated or predecease their partners. Would the spouse have a precise inventory of all of the couple’s assets? Would he be aware of the strategies in place to keep the whole thing up and running? Where to go for cash? How much he can safely spend each year? Or whom to turn to for financial advice?

Of course, one simple way to solve the problem is to turn to a financial advisor straightaway. That’s

the best method to ensure there’s no jarring transition when the first partner dies, and having a trusted advisor can provide a lot of peace of mind while both spouses are living, too. But I also often hear from individual investors who say they’re not sure how to find a good-quality advisor, or that the feeonly advisors they’d like to work with have minimum investment amounts that put them out of reach. Even more common, I meet investors who are enjoying managing their own portfolios right now. They can’t see themselves delegating that task to anyone else, or they don’t want to spend money on advice until they really have to do so.

If any of the above descriptors fits you, your portfolio needs a succession plan—a road map for your partner. Here are the key steps to take.

Create a master directory

This is a basic document you should prepare no matter your life stage, serving as an inventory of each asset you own. Here you should include a brief descriptor (“Jill’s Roth IRA”), the financial provider, account number, URL, password, and so forth. Also indicate the beneficiaries for each of these accounts. Once you’ve drafted such a document, you have two key jobs: to encrypt it (or otherwise keep it safe) and alert your spouse or another trusted loved one of its existence and how to gain access to it.

Draft a short-form explanation of your investment approach

Perhaps you’ve prepared an investment policy statement documenting your asset-allocation parameters and policies on matters such as rebalancing and selling. That’s important. But chances are you wrote your IPS to keep yourself on track, not inform your spouse of what you’re doing. If your spouse finds your IPS inscrutable, it’s time to go back to the drawing board and draft something more succinct, in plain English rather than investment jargon. Think about the basic questions you would ask if you took over someone’s financial plan without much (or any) advance preparation. Headings might include: How much you can safely spend each year without running out of money Which accounts to tap for living expenses on an ongoing basis The basics of required minimum distributions and which accounts require them Which accounts to tap as a last resort or that you have earmarked for heirs An outline of the three or four most important financial-planning tasks you handle each quarter and each year. (Forget anything that’s in the category of “nice to do”; stick to the basics.)

Automate what you can

To help ensure none of your usual financial-planning to-dos fall by the wayside, consider automating the most

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TIPS TO AVOID IRA HEADACHES Common pitfalls that can trip up newbies and seasoned investors alike

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or a vehicle with an annual contribution limit of just $6,000 ($7,000 for those over 50), investors sure have a lot riding on IRAs. Assets across all IRA accounts topped more than $7.3 trillion dollars during the third quarter of 2014, making the vehicle the top receptacle for retirement assets in the U.S., according to data from the Investment Company Institute. In addition to direct annual contributions, much of the money in IRAs is there because it has been rolled over from company retirement plans of former employers.

Opening an IRA is a straightforward matter — pick a brokerage or mutual fund company, fill out some forms, and put money into the account. Yet there are plenty of ways investors can stub their toes along the way. They can make the wrong types of IRA contributions — Roth or Traditional — or select the wrong types of investments to put inside the tax-sheltered wrapper.

And don’t forget about the tax code, which delineates the ins and outs of withdrawals, required minimum distributions, conversions, rollovers and recharacterizations. Rules as byzantine as these provide investors with plenty of opportunities to make poor decisions that can end up costing them money.

Here are 12 common mistakes that investors can make with IRAs, as well as some tips on how to avoid them:

1 a portion of that raise to your investment program. One of the most seamless ways to do it, if you are also contributing to a 401(k), is to bump up your company retirement plan contribution at the same time you anticipate that raise. That way you don’t get used to that higher paycheck because you’re steering at least a portion of it into your 401(k) plan right away.

Because this is such a beneficial way for workers to increase their savings rates, a lot of companies employ a feature in their 401(k) plans called “auto-escalate.” It’s just a box that you’ve got to check on your 401(k) plan website, or whatever system you use to enroll; you’re telling your employer to automatically steer a predetermined portion of every raise you receive into your 401(k). That can be a nice way to say, I’m going to continue to increase my contributions and do so with a lot of discipline.

Stipp: Another area where people sometimes are able to free up some cash is by refinancing, and investing some of that money could be a way to bump up your savings.

Benz: One silver lining we’ve seen with low interest rates right now is that mortgage rates are still quite low. We’ve seen a lot of people queue up to refinance. Of

course, standards are still pretty stringent on refinancing, so not everyone who wants to has been able to refinance. But for those who qualify, refinancing can be a nice way to free up some extra income in the household that you in turn can shuttle into your retirement savings plan.

When you think about someone refinancing from, say, a 4.5 percent 30-year loan into a 3.75 percent 15-year loan, assuming a $200,000 mortgage, that can free up an extra $100,000 into the household that otherwise would have gone to mortgage payments over the life of the loan. That money, in turn, can be steered into an IRA or some such savings vehicle.

Here again, I think that idea of enforced discipline to invest those mortgage savings can be valuable.

Any fund company or brokerage firm will let you turn on automatic contributions. They really like when investors invest this way, so they make it easy. Think about using one of those automatic investment programs, whereby you’re just saying take this amount out of my checking account every month, and do it until I tell you to stop. Most investors, if they do set up a plan like this, don’t stop it. They tend to stick with it.

So, it’s a nice way to increase your savings rate and keep Morningstar it up.

R YOUR PORTFOLIO important ones. For example, you can make sure that distributions from your income-producing securities get spilled directly into your bank account, thereby providing cash for near-term living expenses. You can also automate your required minimum distributions from your IRAs and 401(k)s, and use the auto-payment feature on your online banking platform to ensure that you don’t miss your most important bills. If you pay quarterly estimated taxes, and most retirees do, you can make those payments electronically via the IRS’ website (irs.gov).

Begin building your team

If your partner has no interest in or aptitude for financial matters, it’s unrealistic to expect he will know how to identify an appropriate financial advisor. The financial-advisory landscape is a jumble of designations, and business models and can be off-putting. As a result, people without a lot of financial knowledge often choose advisors based on their interpersonal skills rather than making an objective assessment of the individual’s financial acumen and whether the business model is a good fit. Even if your plan is to not hire an advisor right away, the onus is on you to vet some advisors for your spouse to ensure their investment approach is palatable, their fee structure is fair, and that you can meet the minimum initial investment amount. I’m a believer in

asking for referrals from related professionals—such as your accountant or your estate-planning attorney—rather than relying on the friends and family network for recommendations.

Simplify

Do all of the above steps make your head hurt? If so, the best way to reduce your succession-planning workload—and the potential workload of your spouse—is to streamline your portfolio. You can reduce the number of moving parts by collapsing multiple accounts of a given type into a single account at one firm—for example, merge multiple joint taxable accounts into a single one and purge your portfolio of so-called onesies, which are small pools of assets held here and there. True, there’s no single firm that’s the absolute best at every investment type, but a handful of firms (such as Vanguard and T. Rowe Price) field solid options in all of the major asset classes. In addition to streamlining the number of accounts you hold, it’s also wise to switch to lower-maintenance options, such as index funds, and away from higher-maintenance options, such individual stocks and bonds, as you get further into retirement. In so doing, you’ll reduce your own portfolio-oversight obligations and simplify life for your spouse if he eventually inherits Morningstar those duties.

Waiting until the 11th hour to contribute

Investors have until their tax-filing deadline — usually April 15 — to make an IRA contribution if they want it to count for the year prior. Many investors take it down to the wire. Those last-minute IRA contributions have less time to compound — even if it’s only 15 months at a time — and that can add up to some serious money over time. Investors who don’t have the full contribution amount at the start of the year are better off initiating an auto-investment plan with their IRAs, investing fixed installments per month until they hit the annual limit.

2

Assuming Roth contributions are always best

Investors have heard so much about the virtues of Roth IRAs — tax-free compounding and withdrawals, no mandatory withdrawals in retirement — that they might assume that funding a Roth instead of a traditional IRA is always the right answer. It’s not. For investors who can deduct their traditional IRA contribution on their taxes — their income must fall below the limits — and who haven’t yet saved much for retirement, a Traditional deductible IRA may, in fact, be the better answer. That’s because their in-retirement tax rate is apt to be lower than it is when they make the contribution, so the tax break is more valuable to them now.

3

Thinking of it as an either/or decision

4

Making a nondeductible IRA contribution for the long haul

Deciding whether to contribute to a Roth or traditional IRA depends on your tax bracket today versus where it will be in retirement. If you have no idea, it’s reasonable to split the difference: Invest half of your contribution in a traditional IRA (deductible now, taxable in retirement) and steer the other half to a Roth (after-tax dollars in, tax free on the way out). This can also be a strategy for 401(k) contributions, if you have the option to contribute to either a Traditional or Roth 401(k).

If you earn too much to contribute to a Roth IRA, you also earn too much to make a traditional IRA contribution that’s deductible on your tax return.

The only option open to taxpayers at all income levels is a traditional nondeductible IRA. While investing in such an account and leaving it there might make sense in a few instances, investors subject themselves to two big drawbacks — required minimum distributions and ordinary income tax on withdrawals. The main virtue of a traditional nondeductible IRA is as a conduit to a Roth IRA via the “backdoor Roth IRA maneuver.” With a backdoor Roth IRA, the investor makes a contribution to a nondeductible IRA and then converts those monies to a Roth shortly thereafter. (No income limits apply to conversions.) Note that the clock on backdoor Roth IRAs could be ticking: President Obama proposed closing the backdoor Roth IRA loophole in his most recent budget proposal. For now, though, it’s a viable maneuver for affluent retirement savers.

5

Assuming a backdoor Roth IRA will be tax free

The backdoor Roth IRA should be a tax-free maneuver in many instances.

After all, the investor has contributed money that has already been taxed, and

if the conversion is executed promptly (and the money is left in cash until it is), those assets won’t have generated any taxable investment earnings, either. For investors with substantial traditional IRA assets that have never been taxed, however, the maneuver may, in fact, be partially — even mostly — taxable.

6

Assuming a backdoor Roth IRA is off-limits

7

Not continuing to contribute later in life

8

Not gifting with IRAs

9

Forgetting about spousal contributions

Investors with substantial traditional IRA assets that have never been taxed shouldn’t automatically rule out the backdoor IRA idea, however. If they have the opportunity to roll their IRA into their employer’s 401(k), they can effectively remove those 401(k) assets from the calculation used to determine whether their backdoor IRA is taxable.

True, investors can’t make traditional IRA contributions after age 70 1/2. They can, however, make Roth contributions, assuming they or their spouse have enough earned income (from working, not from Social Security or their portfolios) to cover the amount of their contribution. Making Roth IRA contributions later in life can be particularly attractive for investors who don’t expect to need the money in their own retirements but instead plan to pass it on to their heirs, who in turn will be able to take tax-free withdrawals.

Speaking of earned income, as long as a kid in your life has some, making a Roth contribution on his or her behalf (up to the amount of the child’s income) is a great way to kick-start a lifetime of investing. Per the IRS’ guidelines, it doesn’t matter whether the child actually puts his or her own money into the IRA (there are, after all, movie tickets and Starbucks beverages to be purchased). What matters is that the child’s income was equal to or greater than the amount that went into the account. The IRA contribution can come from you.

Couples with a non-earning spouse may tend to short-shrift retirement planning for the one who’s not earning a paycheck. That’s a missed opportunity. As long as the earning spouse has enough earned income to cover the total amount contributed for the two of them, the couple can make IRA contributions for both individuals each calendar year. Maxing out both spouses’ IRA contributions is, in fact, going to be preferable to maxing out contributions to the earning partner’s company retirement plan if it’s subpar.

10

Delaying contributions because of short-term considerations

Investors — especially younger ones — might put off making IRA contributions, assuming they’ll be tying their money up until retirement. Not necessarily. Roth IRA contributions are especially liquid and can be withdrawn at any time and for any reason without taxes or penalty, and investors may also withdraw some of their traditional IRA money without penalty under very specific circumstances, such as a firsttime home purchase or college funding.

While it’s not ideal to raid an IRA prematurely, doing so is better than not contributing in the first place.

11

Running afoul of the 5-year rule

12

Thinking of an IRA as ‘mad money’

The ability to take tax-free withdrawals in retirement is the key advantage of having a Roth IRA. But even investors who are age 59½ have to satisfy what’s called the five-year rule, meaning that the assets must be in the Roth for at least five years before they begin withdrawing them. That’s straightforward, but things get more complicated if your money is in a Roth because you converted traditional IRA assets. Check with an advisor if this applies to you.

Many investors begin saving in their 401(k)s and start to amass sizable sums there before they turn to an IRA. Thus, it might be tempting to think of the IRA as “mad money,” suitable for investing in niche investments. Don’t fall into that trap. While an IRA can indeed be a good way to invest in asset types that aren’t offered in a company retirement plan, ongoing contributions to the account, plus investment appreciation, mean that an IRA can grow into a nice chunk of change over time.

It makes sense to populate it with core investment types, such as diversified stock, bond and balanced Morningstar funds.

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ESSENTIAL STEPS TO TAKE BEFORE RETIREMENT

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BY CHRISTINE BENZ

t’s a rare newbie investor who has the financial wherewithal — and foresight — to hit the ground running on a retirement-savings plan, making the maximum allowable IRA and 401(k) contributions at the same time she’s getting her career off the ground.

Instead, most investors tiptoe into retirement savings. They might start with token investments in their 401(k) plans (or get opted into them, if they’re not paying attention).

Then, as their finances allow or if they’re dissatisfied with their 401(k) s, they “graduate” into other investment vehicles for their retirement nest eggs, such as IRAs and taxable accounts.

One question investors often ask is, if they have a fixed sum of money to invest every month or every year, how should they deploy that cash for their retirement savings? As with many financial-planning questions, there are no one-size-fits-all answers: Variations in investors’ company retirement plans, tax situations and time horizons mean that a retirement-savings hierarchy that makes sense for one individual may not add up for another.

That said, the following framework for retirement savings will be a good starting point for many investors.

Step 1: Invest enough in 401(k)/other company retirement plan to earn matching contributions Why to prioritize it: To take advantage of free money.

De-prioritize if: Your 401(k) offers no matching contributions. In that case, proceed directly to Stop 2.

Diversification has been called the only free lunch in investing. But there’s another: 401(k) matching contributions. Even if a company’s match is lackluster — say, $0.25 on every dollar invested — it’s going to be dif-

ficult to out-earn that rate of return by investing outside of the 401(k) (or 403(b) or 457 plan). And remember: Those matching contributions are in addition to any investment earnings.

Thus, the first stop for individuals just starting out is to contribute at least enough to earn the full match.

If the company provides a match of $0.50 for every dollar invested, up to 6 percent of pay — which is the most common matching configuration— the employee should target a 401(k) contribution of at least 6 percent.

Step 2: Invest in an IRA

Why to prioritize it: Low costs, flexibility, the ability to contribute to a Roth.

De-prioritize if: Your company retirement plan features all the bells and whistles, including ultra-low costs and a Roth option. Alternatively, if you need the legal protections of a 401(k) or if your company offers the perfect 401(k) plan (more on that below), contribute the maximum to the 401(k) before funding an IRA. It doesn’t get much simpler than making contributions to a 401(k) plan: The money comes out of the investor’s paycheck, like it or not.

Moreover, IRAs enjoy no special tax advantages over 401(k)s. So, why bother with an IRA? Costs are one of the key reasons: Many 401(k) plans feature a layer of administrative fees, whereas investors buying into an IRA can invest without that layer. And while 401(k) investors are typically wedded to a specific menu of investment choices, some of which may be high cost, IRA investors are free to invest in a broad gamut of securities, including ultra-low-cost index-tracking mutual funds or exchange-traded funds.

Finally, not all 401(k) plans offer a Roth option, whereas

all IRA investors have the option to contribute to a Roth, assuming they meet the income limits or use the “backdoor Roth IRA” maneuver.

Of course — and here’s one of the big exceptions to the hierarchy — some 401(k) plans are rock-solid, featuring no layer of administrative expenses, extra-low-cost investment options and a full range of features, including the ability to make Roth contributions. If your 401(k) plan ticks all of those boxes, you can go ahead and make a full 401(k) contribution before moving to an IRA. For married couples with a non-earning spouse, funding a spousal IRA also should come next in the hierarchy. Assuming the earning spouse has enough income to cover both her contribution and that of her spouse, the non-earning spouse can accumulate retirement savings in his name and also help build up the couple’s joint retirement nest egg.

Step 3: Invest in company retirement plan up to the limit

Why to prioritize it: The ability to enjoy tax-free contributions and tax-deferred compounding (traditional) or tax-free compounding and withdrawals (Roth).

De-prioritize if: You have plenty of assets in accounts that will be taxed upon withdrawal and you’re close to retirement. If that’s the case, you may want to prioritize saving in a taxable (nonretirement) account instead of maxing out the company retirement plan. Ditto, if there’s a chance you’ll need the money prior to retirement.

For higher-income investors who have significant assets to invest toward their retirement savings, taking advantage of all tax-sheltered retirement-savings options should precede investing in nonretirement accounts. And that’s true even if the 401(k), 403(b), or 457 plan isn’t best of

breed. Investors in traditional 401(k) s contribute pretax dollars and enjoy tax-deferred compounding; further, making pretax contributions reduces adjusted gross income, thereby increasing eligibility for valuable credits and deductions. Investors in Roth 401(k)s, meanwhile, enjoy tax-free compounding and tax-free withdrawals in retirement.

Those tax benefits are the key reason that investing in a 401(k) — even one that’s subpar —trumps investing in a taxable account.

Step 4: Make aftertax 401(k) contributions to the limit Why to prioritize it: The ability to enhance a portfolio’s share of Roth assets, eventually — provided the 401(k) plan allows for the contribution of after-tax dollars.

De-prioritize if: The 401(k) is especially poor or especially costly.

Investors who make the maximum 401(k) contribution of $19,000 ($25,000 if over age 50) in 2019 can contribute at an even higher level — up to $56,000 in total contributions in 2019 for those under age 50 and up to $62,000 in total contributions for those 50-plus — provided their plans allow for contributions of aftertax 401(k) dollars. Those aftertax 401(k) contributions can be converted to Roth IRA assets once the investor has retired, left the company, or is taking in-service distributions from their plans. Morningstar

ERT S EXPG T INSI H

RETHINK REBALANCING I

BY CHRISTINE BENZ

nvestment gurus Harold Evenksy and Bill Bernstein are fans. Vanguard founder Jack Bogle? Not all that much.

I’m talking about rebalancing — the practice of bringing a portfolio’s allocations back into line with its targets by selling appreciated securities and adding them to underperforming parts of the portfolio.

Bogle isn’t totally sold on rebalancing for a diversified portfolio of stocks and bonds for the simple reason that it will tend to detract from returns. If stocks outperform bonds, as they typically do over long periods of time, an investor will earn a better return by letting the portfolio’s stock allocation ride than trimming it on an ongoing basis.

Moreover, rebalancing can entail costs — both trading costs and tax costs — another reason that Bogle isn’t a huge believer, except at big market inflection points.

Proponents of rebalancing generally concede those points. Rebalancing between stocks and bonds will tend to reduce a portfolio’s return over most long-

term market environments. Instead, the main benefit of rebalancing among stocks and bonds is in the realm of risk reduction.

Thus, it stands to reason that the virtues of traditional rebalancing — among asset classes —are greatest for investors who value that risk reduction the most. On the short list are those investors who, unnerved by market volatility, have tended to reduce their portfolios’ risk levels after the market has fallen a great deal. Such investors would be particularly well served by rebalancing, or perhaps better yet, employing funds that do that rebalancing for them, such as target-date or allocation funds.

Meanwhile, younger investors, say, those under 50 who aren’t overly flummoxed by volatility in their stock-heavy portfolios, can probably get by with infrequent rebalancing, or none at all.

(They may benefit more from intra-asset rebalancing, however; for example, periodically scaling back their largecap weightings after such stocks have outperformed and adding the money to small- and mid-caps.)

For pre-retirees and retirees, however, rebalancing is essential, regardless of risk tolerance. Not only can it help them sidestep all sorts of ill effects from overly heavy equity weightings in the years leading up to retirement, but it can aid them in extracting their desired in-retirement cash flows, too.

Risk tolerance versus risk capacity: What difference does it make?

The reason rebalancing matters more for pre-retirees and retirees than it does for younger investors gets back to the distinction between risk tolerance and risk capacity. Risk tolerance describes an investor’s ability to psychologically cope with periodic losses in his or her portfolio. Risk capacity relates to whether those losses will be so significant that the investor will need to change his plan.

It’s not uncommon for people in their 50s, 60s, and beyond to have high risk tolerances: They’ve been stress-tested by two major bear markets in the space of 20 years, the market has recovered, and so have their portfolios. What many investors fitting this description may not realize, however, is that their risk

The portfolio strategy is vital for many capacities have declined even as their risk tolerances have remained the same or even grown. And when a too-high equity allocation is combined with higher equity valuations and a shortened time horizon before spending, the results can be disastrous.

Rebalancing can help with cash flows, too

Protecting against market downdrafts isn’t the only reason retirees should consider rebalancing. A subtype of rebalancing, in which the proceeds from appreciated assets are spent rather than reinvested, can also prove advantageous as a means of unlocking cash flow from a portfolio during retirement. Such a strategy also serves to reduce risk.

That’s a neat trick when you consider that today’s low yields make it difficult to subsist on yield alone and have forced income-centric retirees to venture into risky securities.

By incorporating rebalancing at both the asset-class and intra-asset-class levels, a retiree can extract cash flow even when the income gods are Morningstar not delivering it.