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GUIDE TO RETIREMENT Expert advice from

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BLUEPRINT FOR THE FUTURE Helping you meet the challenge

he Ànancial 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 Ànancial 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 BeneÀt Research Institute, down from 31 percent in the late 1970s. Yet participation in 401(k) and other deÀned-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 proÀtable — 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 Ànancial 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, created by Morningstar, Inc., and designed by Tribune Content Agency. Since its founding in 1984, Morningstar’s overarching mission has been to help investors reach their Ànancial goals. As director of personal Ànance 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, easyto-implement ideas for retirement planning across life stages. No matter your life stage or level of investment acumen, I’m conÀdent you can Ànd strategies in this supplement that you’ll be able to take and run with.

Christine Benz Director, Personal Finance, Morningstar

ABOUT THE AUTHOR Christine Benz is director of personal Ànance 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. She is the author of “30-Minute Money Solutions: A Step-by-Step Guide to Managing Your Finances” (Wiley, 2010). 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 also served as Morningstar’s director of mutual fund analysis. She has worked as an analyst and editor at Morningstar since 1993.

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WHAT’S INSIDE HIGHLIGHTS Model retirement portfolios for both retirement savers and retirees: Designed for investors at various life stages and with varying risk tolerances — from 20-somethings to 70-somethings — these portfolios are based on Morningstar’s Lifetime Allocation Indexes and comprise mutual funds that receive the highest ratings from Morningstar’s analyst team. Details on the “bucket” approach to retirement planning: Even though CD and bond yields are low, the bucket system enables you to draw the cash you need from your portfolio during retirement while maintaining a stock/bond portfolio for long-term growth. Advice on getting the most from your retirement savings bucks: We’ve included tips on how to bump up your savings rate as painlessly as possible, while also making the most out of tax-advantaged retirement savings vehicles like 401(k)s and Individual Retirement Accounts (IRAs). Practical guidance on how to maximize your payout from Social Security: We interviewed Phil Moeller, one of the country’s foremost experts on Social Security planning, to get his must-know strategies for deciding when and how to claim your beneÀts.

A HEAD START ON A SMART PLAN

4 Take it from Felix, big assumptions can mess up your plan 7 A hierarchy for retirement savings 10 3 simple ways to bump up your savings rate 13 How good is your 401(k) plan? 16 Beware these 20 IRA mistakes CLOSING IN ON RETIREMENT

20 Working past 65: 3 ways to make it less of a chore 22 3 ways to maximize Social Security beneﬁts 24 2 key decisions for your retirement withdrawal strategy YOUR POST-RETIREMENT COMFORT ZONE

28 A new vocabulary for retirement planning 30 How to make money last in retirement 34 Retirees, are you spending too much? 36 7 retirement-portfolio withdrawal mistakes to avoid PORTFOLIOS FOR SAVERS AND RETIREES

40 The Bucket Approach to retirement allocation 42 Bucket portfolios for retired investors 45 Retirement saver portfolios

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“Odd Couple” archive image/Paramount Television

A HEAD START ON A SMART PLAN

TA K E I T F R O M F E L I X , BIG ASSUMPTIONS

CAN MESS UP

YOUR PLAN By Christine Benz

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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 CofÀna has said that longterm, inÁation-adjusted returns in the 4.5 percent

to 6 percent range are realistic for stocks. Vanguard founder Jack Bogle’s forecast for inÁation-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 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 (inÁation-adjusted) return.

Dangerous Assumption 2: That inﬂation will be mild or nonexistent In a related vein, currently benign inÁation Àgures may make it tempting to ignore, or at least downplay, the role of inÁation in your retirement planning. Like robust return assumptions, modest inÁation assumptions can help put a happy face on a retirement plan. But should inÁation 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 inÁation will stay good and low in the years leading up to and during retirement, conservative investors should use longer-term inÁation 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 inÁation forecasts based on their actual consumption baskets. For example, food costs are often 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 inÁation 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 inÁation than any other asset class, as well as Treasury InÁation-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 Àling can all 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 Ànancial 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 BeneÀt Research Institute’s Retirement ConÀdence 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 years.

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Dangerous Assumption 4: That you’ll receive an inheritance Here’s the good news: While it’s a convention in movies for children to be crestfallen when their parents don’t leave them an inheritance, a recent study published in The Gerontologist showed such surprises to be relatively rare. In fact, the study found that just the opposite scenario is common: More parents intend to leave their children an inheritance than the children expect to receive one. A Fidelity survey found that adult children underestimate the value of their parents’ estates, to the tune of $300,000, on average. But that doesn’t mean there’s not the potential for some adult children to receive less than they expected.

Increasing longevity, combined with long-term care needs and rising long-term care costs, means that even parents who intend for their children to inherit assets from them may not be able to. Alternatively, the parents may not be inclined to give at all, even if they have the money: A U.S. Trust survey found that wealthy baby boomers are less likely than other generations to believe in leaving money to their heirs; just 53 percent of those boomers surveyed said they believe that leaving an inheritance is important, whereas 68 percent of high-net-worth investors over age 69 said that it’s important to them to do so. Adult children who expect an inheritance that doesn’t materialize may be inclined to overspend and undersave during their peak earning years. And

by the time their parents pass away and don’t leave them a windfall — or leave them much less than they expected — it could be too late to make up for the shortfall.

What to do instead: Don’t rely on unknown

unknowns. If you’re incorporating an expected inheritance into your retirement plan, it’s wise to begin communicating about that topic as soon as possible. Alternatively, if you don’t want or need an inheritance but suspect that your parents are forgoing their own consumption to give you one, you can have that conversation, too. Q

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A HEAD START ON A SMART PLAN

HIERARCHY

FOR

RETIREMENT

SAVINGS

What retirement vehicles to invest in — and in what order

t’s a rare newbie investor who has the Ànancial 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 Ànances allow or if they’re dissatisÀed 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 Àxed sum of money to invest every month or every year, how should they

deploy that cash for their retirement savings? As with many Ànancial-planning questions, there are no one-size-Àts-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. (Note that this hierarchy does not factor in nonretirement Ànancial goals, such as amassing an emergency fund, saving for college or investing for short- and intermediate-term Ànancial goals.)

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Stop 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. DiversiÀcation 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 difÀcult 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 Àrst 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 conÀguration — the employee should target a 401(k) contribution of at least 6 percent, too.

Stop 2: Invest in an IRA Why to prioritize it: Low costs, Áexibility, the ability to contribute to a Roth. De-prioritize if: Your company retirement plan features all the bells and whistles, including ultralow 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? Why not Àll up that 401(k) to the max, assuming you can spare the $18,000 maximum allowable contribution ($24,000 for savers over age 50) in 2015? 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. (Investors with very small IRAs may, however, be on the hook for account-maintenance fees.) And while 401(k) investors are typically wedded to a speciÀc 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 rocksolid, 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.

Stop 2a: Invest in a spousal IRA Why to prioritize it: To amass retirement savings for non-earning spouse. De-prioritize if: The 401(k) of the spouse with earnings is rock-solid; in that case, fully funding that 401(k) plan could reasonably come before funding IRAs for either spouse. For married couples with a non-earning spouse, funding a spousal IRA 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. Because non-earning spouses don’t have the opportunity to contribute to company retirement-savings vehicles such as 401(k)s, 403(b)s, and 457 plans, the spousal IRA is the only game in town.

Stop 3: Invest in company retirement plan up to the limit Why to prioritize it: The ability to enjoy taxfree 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 signiÀcant 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 beneÀts are the key reason that investing in a 401(k) — even one that’s subpar — trumps investing in a taxable account.

However, it’s worth noting that the beneÀts of investing in a 401(k) are magniÀed over longer time horizons; investors who are close to retirement will beneÀt less from the tax deferral of a traditional 401(k) simply because the money will have less time to compound in the account. Moreover, such investors may value tax diversiÀcation in retirement. By investing in a taxable account, they’ll be able to avoid required minimum distributions and pay capital gains taxes — rather than higher ordinary income taxes — when they eventually withdraw the money. If that’s the case, they may want to prioritize investing in a taxable (nonretirement) account over making additional 401(k) contributions as they get close to retirement.

Stop 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 have already made the maximum 401(k) contribution of $18,000 ($24,000 if over age 50) in 2015 can contribute at an even higher level — up to $53,000 in total contributions in 2015 — provided their plans allow for contributions of aftertax 401(k) dollars. Those after-tax 401(k) contributions can eventually be converted to Roth IRA assets once the investor has retired, left the company or is taking in-service distributions from their plans. Such contributions will tend to be less attractive for investors who have particularly poor or costly 401(k) plans; the costs of investing in a very poor plan have the potential to erode the eventual tax savings associated with having more Roth assets.

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Stop 5: Invest in taxable account Why to prioritize it: You’re aiming for tax diversiÀcation in retirement and already have a sizable share of your assets in tax-deferred and Roth accounts. Ditto, if there’s a chance you’ll need to take out your money prior to retirement or you expect to be in the 0 percent tax bracket for capital gains when you withdraw your money. De-prioritize if: You haven’t yet taken advantage of tax-advantaged accounts that are available to you and you have a long time horizon for your money.

Investing inside of a taxable (nonretirement) account offers the most possible Áexibility, albeit without the tax breaks that accompany the aforementioned investment wrappers. Not only can you invest in nearly anything inside of a taxable account, but there are no withdrawal requirements either. You can pull the money out whenever you need it, but you can also let it build for as long as you want; any taxable assets that your heirs inherit from you will receive a step-up in basis, too. And while you’ll need to invest after-tax dollars in the account, you’ll owe capital gains taxes (lower than ordinary income taxes,

and 0 percent for investors in the 10 percent and 15 percent income tax brackets) when you sell. As attractive as all of that Áexibility is, the tax beneÀts conferred by IRAs and company retirement plans usually make up for any extra costs or other drawbacks associated with those plans, especially for investors with longer time horizons. Q

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A HEAD START ON A SMART PLAN

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3 SIMPLE WAYS

to bump up your savings rate

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 Ànance 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-year-old, 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 Ànd 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 Àrst 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 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 beneÀcial 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.

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Stipp: Another area where people sometimes are able to free up some cash is by reÀnancing, 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 reÀnance. Of course, standards are still pretty stringent on reÀnancing, so not everyone who wants to has been able to reÀnance. But for those who qualify, reÀnancing 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 reÀnancing 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 Àrm 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 it up. Q

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A HEAD START ON A SMART PLAN

How good is your

401(k) plan? A primer about what makes a good plan – and when you should lobby for change

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our company retirement plan may well be getting better. The introduction of “nudge” features like automatic enrollment and autoescalation (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 is also seeing more and more index funds in 401(k) plans, which usually feature ultralow costs. But there are still 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 Àrm that lacks a big 401(k) kitty. Moreover, smaller Àrms, by necessity, frequently require employees to multitask: At a smaller Àrm, 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 Ànd and communicating it to your 401(k) committee or the individual who oversees your Àrm’s beneÀts 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. Unfortunately, you won’t be able to Ànd 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 Ànd them and how you can benchmark them.

Matching contributions

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 administrativeexpense 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 Áag that you have a highcost plan. After all, those expenses come on top of whatever the underlying investments charge.

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 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 conÀguration 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.

Does your plan offer the basic portfolio building blocks for workers at various life stages, including well-diversiÀed 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, that may be by design — but it’s fair to ask to be able to build a plain-vanilla stock/bond portfolio within the conÀnes of the 401(k).

Administrative fees

Quality of investment lineup

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

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

Investment lineup breadth

Although company retirement plans are improving, there are still huge variations in plan quality across employers. Checking up on your plan can help you build a case for improving it.

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attention to what share classes you can buy: Does your plan hold highercost 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.

Additional features 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 aftertax 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 your 401(k) plan. Q

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A HEAD START ON A SMART PLAN

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20 IRA BEWARE THESE

MISTAKES

These missteps can trip up newbies and seasoned investors alike For a vehicle with an annual contribution limit of just $5,500 ($6,500 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.

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pening an IRA is a straightforward matter — pick a brokerage or mutual fund company, Àll 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 20 mistakes that investors can make with IRAs, as well as some tips on how to avoid them:

Waiting until the 11th hour to contribute

Investors have until their tax-Àling 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 Àxed installments per month until they hit the annual limit.

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.

Thinking of it as an either/or decision

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).

Making a nondeductible IRA contribution for the long haul

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.)

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.

Assuming a backdoor Roth IRA is off-limits

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.

Not continuing to contribute later in life

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.

Not gifting with IRAs

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.

Forgetting about spousal contributions

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.

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 speciÀc circumstances, such as a Àrst-time home purchase or college funding. While it’s not ideal to raid an IRA prematurely, doing so is better than not contributing in the Àrst place.

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Running afoul of the 5-year rule

No strategy for minimum distributions

The ability to take tax-free withdrawals in retirement is the key advantage of having a Roth IRA. But even investors who are age 59 1/2 have to satisfy what’s called the Àve-year rule, meaning that the assets must be in the Roth for at least Àve 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.

Required minimum distributions from Traditional IRAs, which start post-age 70 1/2, are the bane of many afÁuent retirees’ existences, triggering tax bills they’d rather not pay. But such investors can, at a minimum, take advantage of RMD season to get their portfolios back into line, selling highly appreciated shares to meet the RMDs and reducing their portfolios’ risk levels at the same time. Think about tying RMDs in with year-end portfolio maintenance.

Thinking of an IRA as ‘mad money’

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 diversiÀed stock, bond and balanced funds.

Doubling up on tax shelters

In addition to avoiding niche investments for an IRA, it also makes sense to avoid any investment type that offers tax-sheltering features itself. That’s because you’re usually paying some kind of a toll for those tax-saving features, but you don’t need them because the money is inside of an IRA. Municipal bonds are the perfect example of what not to put in an IRA; their yields are usually lower than taxable bonds’ because that income isn’t subject to federal — and, in some cases, state — income taxes. Master limited partnerships are also generally a good Àt for a taxable account, not inside of an IRA.

Not paying attention to asset location

Because an IRA gives you some form of a tax break, depending on whether you choose a Traditional or Roth IRA, it’s valuable to make sure you’re taking full advantage of it. Higheryielding securities such as high-yield bonds and real estate investment trusts, the income from which is taxed at investors’ ordinary income tax rates, are a perfect Àt for a Traditional IRA, in that those tax-deferred distributions take good advantage of what a Traditional IRA has to offer. Meanwhile, stocks, which have the best long-run appreciation potential, are a good Àt for a Roth IRA, which offers tax-free withdrawals.

Triggering a tax bill on an IRA rollover

A rollover from a 401(k) to an IRA — or from one IRA to another — isn’t complicated, and it should be a tax-free event. However, it’s possible to trigger a tax bill and an early withdrawal penalty if you take money out of the 401(k), with the intent to do a rollover, and the money doesn’t make it into the new IRA within 60 days.

Not reinvesting unneeded RMDs

In a related vein, retired investors might worry that those required IRA distributions will take them over their planned spending rate from their portfolios. (Required minimum distributions start well below 4 percent but escalate well above 6 percent for investors who are in their 80s.) The workaround? Invest those unneeded RMDs in a Roth IRA if you have earned income or — more likely — in tax-efÀcient assets inside of a taxable account.

Not using qualiﬁed charitable distributions

RMD-subject investors also miss an opportunity if they make deductible charitable contributions rather than directing their RMDs (or a portion of them) directly to charity. That’s because a qualiÀed charitable distribution — telling your Ànancial provider to send a portion of your RMD to the charity of your choice — reduces adjusted gross income, and that tends to have a more beneÀcial tax effect than taking the deduction. The hitch is that Congress typically only renews the provision that allows qualiÀed charitable distributions at the very end of the year, so interested investors have to delay their distributions until then.

Not paying attention to beneﬁciaries

BeneÀciary designations supersede expensive, carefully drawn-up estate plans, but many investors scratch them out with barely a thought, or make them once but don’t revisit them ever again. Be sure you’ve thoughtfully designated your IRA beneÀciaries.

Not seeking advice on an inherited IRA

Inheriting an IRA can be a wonderful thing, but it’s not as simple as it sounds. The inheritor will have different options for what to do with the assets depending on his or her relationship to the deceased, and can inadvertently trigger a big tax bill by tapping the IRA assets without exploring all of the options. The lesson: If you’ve been lucky enough to inherit an IRA, it can pay to seek professional advice. Q

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CLOSING IN ON RETIREMENT

Working past 65 3 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 long-term 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 toward retirement today won’t have the Ànancial safety net of a pension. Yet they haven’t amassed enough of their own Ànancial 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 beneÀts 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 post-65 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 Àrm 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 beneÀts 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 Àrst to retire, he or she could begin claiming beneÀts at age 62, while the higher-earning spouse delays beneÀts until age 70, at which time the lower-earning spouse can switch to

a spousal beneÀt. (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 can also call the Social Security administration or visit a local ofÀce if you have speciÀc questions about your own situation.)

Make it a labor of love If you’ve logged a long career within a speciÀc Àeld or with one company, staying put for the rest of your working years might deliver the highest Ànancial 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 Ànancial 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 gratiÀcation. Such positions may not offer the same Ànancial rewards that your old 9-to-5 job did, but if you’re doing something you love, the trade-off might be worth it. Q

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CLOSING IN ON RETIREMENT

3 ways to maximize

SOCIALSECURITY

BENEFITS

What are some key rules to bear in mind when deciding how and when to claim Social Security beneﬁts? Morningstar’s Christine Benz recently discussed this topic with Phil Moeller, co-author of a new book about Social Security, “Get What’s Yours.” Christine Benz: Let’s talk about the three rules to maximize your Social Security beneÀts that you lay out in “Get What’s Yours.” The Àrst is to be patient. What are the virtues of potentially delaying claiming Social Security? Phil Moeller: When we started researching the book, we found out that most people take their beneÀts at age 62 or close to it, which is the earliest they can take beneÀts. If you wait until age 70, your beneÀts are 76 percent higher every month than they are at age 62. Being patient doesn’t necessarily mean always waiting until age 70. What it does mean is that you need to do your homework; you shouldn’t just rush down to the Social Security ofÀce on your 62nd birthday. You need to learn the rules of how you should claim your beneÀts. Being patient, in some cases, does involve waiting, but it always involves doing some learning and making sure you understand the implications of the beneÀt choices you have. Benz: Are there any situations where it may not make sense to delay — at least not until age 70? Moeller: There are many situations where it doesn’t make sense to delay to age 70. For instance, spousal beneÀts don’t get any higher if you wait until past full retirement age, which for most people is 66 these days. As such, there is no reason to delay a spousal beneÀt past the age of 66. In addition, in some cases, people need the money, and delaying isn’t an option. And in other cases, people have signiÀcant health issues, or maybe they have a family history that suggests they are not going to live a long time. In those cases, we think it might well be in someone’s interest to claim early. And then there is another area where it might be in one’s interest to claim early: If you’ve retired and you have school-age children at home, they can claim a beneÀt based on your earnings record. Let’s say you’re 62 years old, and you have teenagers or grade-schoolers at home. If you wait until age 70 to claim your beneÀts, your children would be too old to claim beneÀts on your record at that point. It’s not only your beneÀt that’s at stake, but it could be the beneÀts of your children, too. You really need to do your homework and say, “Well, maybe in this case, it would be better if I took beneÀts early because my kids can get beneÀts on my record and I can help pay for their college educations.” It might make sense to claim early if you’re a parent of minor children. Benz: Is there any beneÀt to waiting beyond age 70 to begin claiming your beneÀts? Moeller: No. We get a lot of questions about that, because people are worried about the tax consequences of suddenly having that beneÀt at age 70 raise their taxes. But I’ve never

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been able to come up with a scenario where you end up with less money by taking the beneÀt at 70 than you would by deferring longer. Benz: Let’s get into another of the rules that you discuss in depth in your book. The rule is “get all of what’s yours.” If we’ve been working, we are, of course, entitled to claim retirement beneÀts on our own work records. But there are other types of beneÀts you alluded to, such as spousal beneÀts. Let’s talk about the full array of additional beneÀts that individuals may be eligible for in addition to their own retirement beneÀts. Moeller: It’s sort of a mind-boggling array of opportunities and choices. You have your beneÀt, and a spousal beneÀt, as you said. If you’re divorced, you can get an ex-spousal beneÀt. As I said, your children can get beneÀts based on your work record. If you pass away, there are survivor beneÀts. There are also survivor beneÀts that may be available for family members. In some cases, your parents might be able to claim a survivor beneÀt based on your record if you were supporting them, if you were basically the householder. The key thing to keep in mind is that you can’t take the full value of two beneÀts at once. When you really want to get everything that’s yours, you want to think about scenarios in which you can take the full value of one beneÀt, while the other beneÀt is deferred, and then you can switch to the other beneÀt at a later time. The greatest example of that is the spousal beneÀt, which we talk about at great length in the book. And the classic scenario is to take your spousal beneÀt while your own retirement beneÀt grows by 8 percent per year between your full retirement age and age 70. That’s the closest thing we’ve found to what we call “free money,” because you don’t lose any of your own beneÀts. There’s a chance that the government will eventually eliminate this so-called loophole, because this can be seen as more of a beneÀt for the wealthy, and perhaps it’s not really what the program was designed for. And that’s Àne. But our point in the book is that people should get whatever they can under the rules that exist today — and you can execute this strategy today. Benz: Let’s go over that scenario that you just outlined, which is often referred to as the Àle-and-suspend strategy. How does Àle-and-suspend work? Moeller: In order for spouse A to collect spousal beneÀts, spouse B has to have Àled for his or her own retirement beneÀt. That’s required to trigger the ability to have a spousal beneÀt. In the classic Àle-and-suspend scenario, when you reach full retirement age, you can Àle for your own Social Security beneÀt and thereby trigger your spouse’s eligibility for spousal beneÀt. Then, you can suspend your own retirement beneÀt so your spouse can get what’s called a “full spousal beneÀt,” which is equal to half of your retirement beneÀt. Then, your own retirement beneÀt

continues to grow by 8 percent per year. Here, timing becomes very important, and we strongly suggest people wait until their full retirement age to take advantage of the spousal beneÀt. Benz: That leads to your third rule for managing your Social Security income stream: Get the timing right. What are some of the key things that people should have in mind when timing Social Security? Moeller: The most important thing is to understand what full retirement age means, as deÀned by Social Security. Full retirement age is now 66. It’s gradually going to rise to age 67, and who knows what future Congresses may do in terms of raising the retirement age even higher. If you claim a beneÀt before full retirement age, bad things usually happen, because when you claim a beneÀt before full retirement age, you often simultaneously trigger a second beneÀt. Here’s an example: A husband has claimed his retirement beneÀt, and his wife wants to claim her spousal beneÀt and she is not yet age 66. If she Àles for a spousal beneÀt, she automatically triggers her own retirement claim, which many people don’t really want to do and they don’t know they are doing it. The reporting forms aren’t clear. You don’t get both beneÀts; you get an amount that’s roughly equal to the greater of the two beneÀts. But then, for the rest of your life, you basically can’t take the optimal amount of beneÀts. When you claim early, you also are subject to what are called “early claiming reductions.” If you claim at age 62, your retirement beneÀt is 25 percent less than what it would be at 66. If you claim a spousal beneÀt at 62, it’s 30 percent less than what it would be at 66. Don’t ask me why they have different penalties; it’s why we needed to write a book. Benz: And you delve into a lot of speciÀc questions in the book, because there are so many different scenarios that involve widows and widowers and divorcees and various family permutations. Moeller: And government workers, in terms of pension offsets and windfall programs that Social Security has. It’s very complicated. We get questions every day that we haven’t seen before. There are a lot of possible combinations. Q

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CLOSING IN ON RETIREMENT

2 key decisions for your

retirement

withdrawal Y

strategy

ou’ve accumulated what seems like a sufÀciently sized nest egg coming into retirement. The next step is to Àgure out how to get your money out of it. At Àrst 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: Àrst, the extent to which they’re comfortable with a Áuctuating payday and, second, whether they want their paycheck to come from income alone or other sources, as well.

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“

Retirement researchers generally consider variable distribution methods as more sustainable than withdrawing a Àxed dollar amount because they’re more market-sensitive.

”

Investors often conÁate 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 Áow. In reality, it’s possible to employ an income-centered strategy that delivers a steady dollar paycheck. Meanwhile, the opposite strategy is also 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 Àxed dollar amount because they’re more market-sensitive. To arrive at the best decision for you, it makes sense to consider each of the following decisions one by one, in full consideration of the pros and cons:

Decision 1: 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 inÁation 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 Àxed-dollar amount: Using this strategy, the retiree takes a speciÀc percentage of his or her portfolio in year one of retirement, then inÁation-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 inÁation 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 Áuctuations; taking too much in down years could leave less in place to bounce back when the market recovers.

The Àxed 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 Àxed 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 Áuctuating paycheck, which may not suit retiree’s lifestyle considerations; taking a Àxed 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 inÁation adjustment in down-market years. Another strategy, discussed in research by Jonathan Guyton and William Klinger, assumes a Àxed-percentage withdrawal method with “guardrails” to ensure that spending never goes above a given ceiling or Áoor.

Pros: Attempts to deliver a fairly stable cash Áow while also staying sensitive to portfolio Áuctuations.

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 don’t guarantee it. Decision 2: Will you concentrate on income, total return or a combination? Once you’ve homed in on a comfortable spending strategy, the next step is to determine where you’ll go for that cash Áow. Will you use the traditional strategy of relying on the income that your bonds and dividend-paying stocks kick off ? Or are you open to taking a cut of your principal now and then, if your portfolio has performed particularly well? Or perhaps you like the idea of blending these two approaches. The income method: The most familiar method for generating retirement cash Áow, this strategy means that you’ll spend your bond and dividend distributions as your portfolio kicks them off.

Pros: Easy to understand and implement; ensures that you don’t touch principal; embeds a sensitivity to stock and bond prices, in that yields are often highest when the market is cheapest.

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Cons: When yields are low, the retiree must either settle for a smaller paycheck or venture into higher-yielding, higher-risk securities; a portfolio built strictly for income may be less diversiÀed than a portfolio built for total return.

The total-return method: Under this approach, maximizing long-term portfolio growth is the key goal. The retiree reinvests all dividend and capital gain distributions and periodically rebalances the portfolio — i.e., scales back on winning positions — to generate living expenses.

Pros: Portfolio may be better diversiÀed than the strictly income-centric one, encompassing non-dividend-paying securities and lower-yielding bonds; rebalancing regimen will tend to improve portfolio’s risk/reward proÀle. Cons: There may be years when rebalancing proceeds are insufÀcient to meet living expenses; can be more complicated to implement than an income-centric strategy. The hybrid method: This approach involves spending income and dividend distributions as they occur, while using rebalancing proceeds to make up any shortfalls in income. The portfolio is built for long-term total return as much as it is for income generation.

Pros: Spending a baseline of income distributions can provide valuable peace of mind; rebalancing helps improve portfolio’s risk/reward proÀle; generated the best returns of any portfolio strategy examined in our back-tests. Cons: Slightly more complicated to implement than either the pure income or pure totalreturn approach. Q

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YOUR POST-RETIREMENT COMFORT ZONE

A new vocabulary

for retirement planning

hen it comes to their Ànances 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 speciÀc 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 Áexible 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 Áames 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 can also 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 incomeminded 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.

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In: Retirement cash ﬂow Out: Retirement income Retirees often obsess about generating income from their portfolios, conÁating 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 dividend-paying stocks as retirement draws near, as such securities often have more stability than stocks without dividends. But retirees can meet their cash Áow 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-Áow resources, the greater the diversiÀcation and Áexibility to maximize the investment portfolio’s risk/reward proÀle.

In: Retirement life-cycle fund Out: Target-date fund The term “target-date fund” deÀnitely has the potential to mislead. For starters, the term “target” could incorrectly promote the notion that such funds will deliver a speciÀc 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 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 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 Áow — for many retirees, and while it’s not the same as an insurance policy you would buy from an agent, the program’s beneÀts 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 beneÀts at full retirement age or later; that way you can earn a higher beneÀt. If you think you need less insurance, you may start taking beneÀts sooner. As with an insurance purchase, a current or, particularly, future Social Security recipient will want to consider the Ànancial strength of the counterparty (in this case, the U.S. government) and the likelihood that beneÀts 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 Ànancial plan, which may necessitate a higher savings rate leading up to retirement or a lower spending rate in retirement. Q

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YOUR POST-RETIREMENT COMFORT ZONE

How to make money

last in retirement

e’re living longer. And even if we’ve saved for our retirement, will we have enough? When should we Àle for Social Security beneÀts? 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, Ànancial 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 long-term care would argue for a larger pool of money that you would need to set aside for your own retirement.

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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?

affects retirees.

“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.”

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 Àve 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 working longer is a great strategy, and it is a great thing to try to do. It is not a plan, though.

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 inÁation 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, retirees are Morningstar: For many, Social Security will be the perhaps too comfortable with their equities. They have only guaranteed lifetime income source. Can you forgotten what it felt like during the bear market. So, if provide some sort of basic rules of thumb or guide- anything, I think many retirees seem to be erring on the lines in terms of how to best treat that beneÀt? side of having too much equity risk in their portfolios. You absolutely do need stabilizers, and that’s why my hyMiller: At a high level, I think delayed claiming is something most people should think about — especially pothetical retirement bucket portfolios include cash, they married couples — because, as has just been pointed out, include high-quality bonds — miserly yields and all. But one person in the couple is likely to exceed the longevity the idea is that those are the ballast for the return-engine numbers, and that’s where Social Security provides a huge piece of your portfolio. beneÀt. Oftentimes, you have situations where people Morningstar: We haven’t had to worry about inget into their late 80s or 90s, and they’ve exhausted their savings, and then Social Security is still there as a bedrock. Áation for a long time. Mark, do you think that inÁation protection still has a place in a retiree portfolio? You can also get into some of these more complex strategies that are becoming more popular, such as “Àle Balasa: I think there is always a place for it. But when and suspend,” where, for couples who reach their full re- you put these inÁation hedges in the portfolio, you still tirement age, the higher earner can Àle but then suspend need to be aware of valuations. Commodities haven’t the beneÀt. The other lower-earning spouse can then done well lately; real estate has had quite a run; TIPS Àle for a spousal beneÀt, while the higher earner waits (Treasury InÁation-Protected Securities), of the three, to claim later, perhaps as late as 70. In terms of delayed perhaps may be the most attractive, in our opinion. You claiming, it’s most important for the higher earner to de- shouldn’t put inÁation hedges in the portfolio blindly. Pay lay as long as possible because, in a married couple, that’s attention to valuations. where you get the biggest bang for your buck. Miller: While it’s probably right that overall general inÁ ation is probably going to stay quiet, seniors are Morningstar: If you are trying to build a portfolio disproportionately affected by health-care inÁation. And that’s going to last for a 25- or 30-year retirement or longer, what are the basic components that you need that continues to run, unfortunately, higher than general inÁation — less than it has, but there is still a debate as to focus on? to whether health-care inÁation could take off again in a Benz: I think a balanced portfolio really is a great start- way that could be really damaging. I don’t know what the ing point. You absolutely need equities for the longevity solution to that is, but I think it needs to be considered risk. You need that growth portion of your portfolio. in the overall risk picture with respect to inÁation that

Benz: I love that idea of customizing your own inÁation targets — thinking about your consumption basket. I believe that food costs, historically, take up a larger share of retiree budgets than they do for the general population. And food costs are on the rise in many cases. The cereal boxes seem to be shrinking. That’s something to keep an eye on.

Morningstar: Let’s talk about some rules of thumb for maximizing your tax-advantaged accounts in retirement. Some say that any Roth assets should be withdrawn last because of the value of tax-free compounding. Christine, are there instances when withdrawing from Roth assets earlier would make sense? Benz: There has been a lot of research in this area. The standard rules about sequencing withdrawals in retirement indicate that you’d go through taxable accounts Àrst, then tax-deferred and then leave Roth until last. But that withdrawal sequence doesn’t make sense in every case. The goal should be, on a year-by-year basis, that you try to land in the lowest possible tax bracket, and that can mean pulling assets from a variety of account types. A tax advisor who is well versed in these issues can really give retirees a helping hand with this challenge.

Miller: One other thing that’s interesting about the tax question has to do with people working longer. The ordinary-income picture starts to get interesting for people who are past that usual retirement age but may be still working. Then, there might be some Social Security income, income coming out of an IRA or 401(k). It gets more complicated. It also starts to trip some unwanted consequences, such as greater taxation of Social Security. Plus, you move into these surcharges on Medicare premiums that kick in around $85,000 in adjusted gross income for an individual, signiÀcantly higher Medicare premium. A variety of things are now in the picture with the “working longer” part of the story that weren’t there before.

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Benz: Required Minimum Distributions from retirement accounts are in the mix, too. We’ve had a very strong market. For some retirees, their RMDs are higher than they had been for many years. That would argue for perhaps pulling from some of those accounts where you would face lighter tax consequences to do so, such as Roth or perhaps a taxable account if you need more money in a given year. Morningstar: The 4 percent rule for retirement withdrawals has been the rule of thumb. You withdraw 4 percent of your assets during your Àrst year of retirement and make an adjustment for inÁation every year thereafter. Nowadays, with bond yields as low as they are, some experts are saying maybe 3 percent is a more comfortable rate. Mark, how do you guide your clients in terms of how much they can safely take out each year? Balasa: It’s one of those rules of thumb that is really tough, because there are so many other extenuating circumstances. There’s a pension; there’s Social Security; there’s an inheritance; we’re going to downsize our home; we’re going to sell the business. All of these things come into the mix. If all you have is a single pot of money and you’re going to live all by yourself, maybe the 3 percent/4 percent rule works. But for most people, you have to do some scenario-planning on your own or with an advisor because there are so many variables. That rule of thumb doesn’t Àt most people’s speciÀc circumstances. Miller: There has also been some great research suggesting a more Áexible approach: Assess it as you go. Spending in retirement doesn’t just move in a straight march upward; it tends to taper off when people hit their 80s. They are less active; they are spending less on entertainment and travel. A straight-line version is not going to get it done for most people. Benz: Common sense is really helpful, too. Pulling back on distributions in those terrible market years will go a long way toward preserving your principal and making your money last. It’s also important to consider time horizon. Certainly, younger retirees — people who have, say, a 40-year time horizon in retirement — should not be using 4 percent as a starting point for distributions. They should be lower. And people who, for whatever reason, want to have a very conservative asset allocation should

also be more careful; 4 percent is probably too high if they have a portfolio that’s heavy on bonds and cash. Morningstar: How should people think about health care spending in retirement? Miller: I would start with Medicare because most of us are going to Àle 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 Áexibility 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. You sign up for Part B, which is outpatient; then you add a drug plan, which is Part D. And you probably add a Medicare supplement plan. 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-term-care insurance something that you recommend for your clients? Balasa: In many cases, our typical client can self-insure because they have sufÀcient 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 Àve years. We’ll put that into their plan, inÁate 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. Others, of course, want it and they can’t get it because they can’t pass the underwriting. Miller: There have been massive price increases with

long-term care policies because the underwriters have had trouble Àguring 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 speciÀc 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 showstopper. Benz: And it’s still a really difÀcult area to do your due diligence, especially with the more complicated annuity types. You really have to know what you are doing before purchasing or even researching such products. And unfortunately, the good information sources are pretty scant. Q

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YOUR POST-RETIREMENT COMFORT ZONE

RETIREES, ARE YOU SPENDING

TOO MUCH?

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 — or spending rate, as Morningstar prefers — is such an important part of retirement planning, pre-retirees and retirees who need guidance should seek the help of a Ànancial 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 Ànancial planner William Bengen. It has subsequently been reÀned — 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 — in dollars and cents — 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 inÁation. 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 (more on this in a moment). 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 proÀle matches those parameters, not every retiree should take the 4 percent guideline and run with it. Indeed, much of the recent research on spending rates has suggested that rather than take 4 percent of a portfolio per year and simply inÁation-adjust that dollar value, 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 Áip 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

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you see the interplay between life expectancy and withdrawal rates. Asset allocation: A retiree’s asset allocation should also 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. Thus, the bond-heavy investor can expect less help from the market in the years ahead. 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 downmarket years and can potentially take more out in years when the market performs well, such as in 2013. The purest way to tie in spending with portfolio performance is simply to take a Àxed 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 Àxed-percentage method, the retiree would never run out of money, but he or she might not be able to make do on the smaller amount. For retirees who aren’t comfortable with such dramatic Áuctuations in their standards of living, it’s possible to employ a hybrid approach: tying

in spending with market movements while also ensuring a basic standard of living. One such strategy blends Àxed-percentage withdrawals with a ceiling and Áoor. A simpler strategy, advanced by T. Rowe Price, allows the retiree to spend a Àxed dollar amount, adjusted upward for inÁation, as in the 4 percent guideline. But the retiree simply forgoes the inÁation adjustment in lean market years. T. Rowe’s research found that even this simple step helped improve portfolios’ sustainability. Q

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YOUR POST-RETIREMENT COMFORT ZONE

RETIREMENT - PORTFOLIO WITHDRAWAL MISTAKES

TO AVOID

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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. For example, holding too much company stock or maintaining a much-too-meek allocation in stocks can more seriously affect a portfolio’s long-run viability. 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 difÀcult 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 seven 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 retirementportfolio 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 inÁation, retirees would be better off staying Áexible 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 Àxed percentage, versus a Àxed dollar amount adjusted for inÁation, 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 Ànd a more comfortable middle ground by using a Àxed percentage rate as a baseline but bounding those withdrawals with a “ceiling” and a “Áoor.” A qualiÀed Ànancial 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 Àxed-dollar withdrawal method — especially if the viability of your plan revolves around a Àxed 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. How much padding to add depends on both how speciÀc you have been in forecasting your expenses (the more speciÀc and forward-looking your forecasts, the less of a fudge factor you’d need to add) as well as how conservative you are (if you don’t want even the slightest chance of running out of money, you’ll need to add more padding/assume a higher spending rate). 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 Àxed amount from a portfolio — whether you’re using a Àxed dollar amount or a Àxed 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.

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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 Àt with the proÀle 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) Àgure, whereas those with moreaggressive 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 Ànancial advisor can help you create a customized spending target based on your mix of investments.

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Mistake 5: Not factoring in the role of

taxes The money you’ve saved in tax-deferred retirementsavings vehicles might look comfortingly plump. However, it’s important to factor in the role of taxes when determining your take-home withdrawals from those accounts. A 4 percent withdrawal from an $800,000 portfolio is $32,000 — perhaps on target with your spending needs — but that amount shrivels to just $24,000, assuming a 25 percent tax hit. 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 beneÀt from consulting with a tax advisor or a tax-savvy Ànancial 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 higheryielding 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 artiÀcial one; whether your withdrawal comes from income or withdrawal of capital, it all counts as a withdrawal. (People are sometimes surprised to hear that the 4 percent guideline assumes that 4 percent is the total portfolio withdrawal, inclusive of both income distributions and withdrawals of principal; it’s not safe to take both your income distributions and 4 percent.) 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 make up for the rest.

Mistake 7: Not getting help

As the preceding missteps illustrate, calibrating in-retirement spending rates is more complicated than it appears at Àrst blush, especially when you

consider issues such as market Áuctuations, taxes, life expectancies and unplanned expenditures. Withdrawalrate planning is so complicated and so important that it’s one area where even dedicated do-it-yourself investors might consider getting a second opinion, just to make sure they’re thinking through all of the right variables and being neither too aggressive nor too conservative in their assumptions. What to do instead: If you’d like to retain control of your portfolio plan while also getting help with your spending-rate assumptions, consider checking in with a fee-only planner who charges on an hourly or per-engagement basis. Visit napfa.org for more information. Q

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PORTFOLIOS FOR SAVERS AND RETIREES

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 Àgure 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 higheryielding alternative holding, such as a shortterm bond fund. A retiree might also consider including an emergency fund within Bucket 1 to defray unanticipated expenses such as car repairs, additional health-care costs and so on.

hose who lived through the 1970s and ’80s no doubt Ànd 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 six-month certiÀcate of deposit was 9.1 percent in 1970 and 13.4 percent in 1980. Of course, inÁation 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 inÀnitesimal 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 Ànancial 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 diversiÀed pool of long-term holdings, with the cash buffer providing the peace of mind to ride out periodic downturns in the long-term portfolio.

Bucket 2 Under our framework, this portfolio segment contains Àve 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 portfolio can be used to reÀll 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 — as they are now — 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 reÀll Bucket 1.

(The all-important) Bucket 1 The linchpin of any bucket framework is a highly liquid component to meet near-term 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

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 to keep the total portfolio from becoming too stock-heavy. By the same token,

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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 into real ones.

Bucket maintenance The basic bucket strategy is straightforward: By maintaining a liquid pool of assets at all times, a retiree can maintain a stable standard of living while also holding a diversiÀed pool of assets that may undergo short-term Áuctuations. But things start to get somewhat more complicated when it comes to “bucket maintenance” — where to go for cash when, or ideally before, the cash bucket runs dry. There are a few different options, outlined below. Each of these strategies has its pros and cons. What I call the “strict constructionist total return” and “opportunistic” approaches will generally make the most sense for retirees wishing to employ a bucket strategy.

The Income-Only Approach Using this strategy, Bucket 1 is reÀlled with whatever income the cash, bond and stock holdings kick off. Pros: Because it doesn’t involve tapping principal, this approach helps assure not only that a retiree won’t outlive his or her assets, but also that there will be money left over for heirs or for in-retirement splurges. In addition, an incomecentric approach is the lowest-maintenance, as it’s easy to automate the income distributions into Bucket 1. Cons: One of the central attractions of the Bucket Approach is that it helps a retiree smooth his or her income stream by holding a static amount in Bucket 1, based on real-life living expenses. But by relying only on income distributions to reÀll Bucket 1, a retiree is apt to Ànd that income stream is buffeted around by the prevailing yield environment. Moreover, given how low yields are currently, the incomegenerating securities in a portfolio may not generate a livable yield at various points in time (like right now), leaving the retiree with no choice but to withdraw principal.

The Strict Constructionist TotalReturn Approach Under this strategy, a retiree reinvests all income, dividends and capital gains back into his or her holdings. The retiree reÀlls Bucket 1 with rebalancing proceeds, periodically selling those holdings that have performed the best, whether stock or bonds, to bring the total portfolio’s asset-class exposures back in line with targets. (Those targets may gradually grow more conservative over time, depending on the assetallocation glide path the retiree is using.) Pros: The big advantage to the total-return approach, in contrast with the one outlined above, is that it’s extremely plugged into market movements and valuation, forcing the investor to sell appreciated assets on a regular basis while leaving the underperforming assets in place or even adding to them. An investor using this strategy during the bear market, for example, would have been trimming high-quality bond holdings to reÀll Bucket 1, leaving potentially undervalued stock positions intact. Cons: Rebalancing too often may prompt a retiree to prematurely scale back on an asset class, thus reducing the portfolio’s total-return potential. That argues for holding at least two to three years’ worth of living expenses in Bucket 1, thereby giving the retiree more discretion over when to sell assets for rebalancing.

The Opportunistic Approach Under this strategy, a retiree takes a catholic approach to reÀlling Bucket 1. Income distributions from cash holdings, bonds and dividend-paying stocks are automatically transferred to Bucket 1. If those distributions are insufÀcient to reÀll Bucket 1, the retiree can look to rebalancing proceeds, tax-loss harvesting and required minimum distributions from Bucket 2 and 3 to top up depleted cash stakes. Pros: By directing income and dividend distributions into Bucket 1, this approach provides a baseline of income for living expenses. Those income distributions may also trend up in periods of market distress, as yields often move in the inverse direction of prices. That extra income, in turn, could help the retiree avoid tapping principal during a market downturn. Cons: This isn’t a “con” as much as an FYI. Because income and dividend distributions aren’t being reinvested, the long-term portfolio’s totalreturn potential may be less than is the case with the above-mentioned strict constructionist totalreturn approach. Q

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PORTFOLIOS FOR SAVERS AND RETIREES

BUCKET PORTFOLIOS for retired investors

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he bucket approach is a strategy for funding retirement cash-Áow needs while also maintaining a diversiÀed 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-Áow 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 Áow 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 inÁation 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 is depleted to meet living expenses, the retiree would reÀll 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 Áip side, investors comfortable with slight Áuctuations 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 inÁation protection as well

as income and a modest amount of capital growth. In all instances, Bucket 2 is anchored by two sturdy, Áexible core bond funds: one short-term and the other intermediate. In addition, it includes exposure to inÁation-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 Áoatingrate) fund, Fidelity Floating Rate High Income, which will tend to have limited interest-rate sensitivity and might also offer a measure of inÁation 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 inÁation protection. This bucket is the growth engine of the portfolios, but note that the core stock holding — Vanguard Dividend Growth — focuses on highquality 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 Áuctuations. Risk-conscious investors might therefore consider scaling back the foreign-stock portion of the portfolio.

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Aggressive Bucket Portfolio

Moderate Bucket Portfolio

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.

Bucket 1: Years 1-2 Bucket 1: Years 1-2 8%: Cash (certiÀcates of deposit, money market accounts, and so on)

10%: Cash (certiÀcates of deposit, money market accounts, and so on)

Bucket 2: Years 3-10 Bucket 2: Years 3-10 8%: Fidelity Short-Term Bond (FSHBX) 10%: Harbor Bond (HABDX) 4%: Vanguard Short-Term InÁationProtected Securities Index (VTIPX) 10%: Vanguard Wellesley Income (VWINX)

Bucket 3: Years 11 and Beyond 10%: Vanguard Total Stock Market Index (VTSMX) 24%: Vanguard Dividend Growth (VDIGX) 13%: Harbor International (HIINX) 8%: Loomis Sayles Bond (LSBRX) 5%: Harbor Commodity Real Return (HACMX)

10%: Fidelity Short-Term Bond (FSHBX) 5%: Fidelity Floating Rate High Income (FFRHX) 15%: Harbor Bond (HABDX) 5%: Vanguard Short-Term InÁation-Protected Securities Index (VTIPX) 5%: Vanguard Wellesley Income (VWINX)

Bucket 3: Years 11 and Beyond 20%: Vanguard Dividend Growth (VDIGX) 10%: Vanguard Total Stock Market Index (VTSMX) 10%: Harbor International (HIINX) 5%: Harbor Commodity Real Return (HACMX) 5%: Loomis Sayles Bond (LSBRX)

Conservative Bucket Portfolio 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 12%: Cash (certiÀcates of deposit, money market accounts, and so on)

Bucket 2: Years 3-10 12%: Fidelity Short-Term Bond (FSHBX) 5%: Fidelity Floating Rate High Income (FFRHX) 20%: Harbor Bond (HABDX) 6%: Vanguard Short-Term InÁationProtected Bond Index (VTIPX) 5%: Vanguard Wellesley Income (VWINX)

Bucket 3: Years 11 and Beyond 23%: Vanguard Dividend Growth (VDIGX) 7%: Harbor International (HIINX) 5%: Harbor Commodity Real Return (HACMX) 5%: Loomis Sayles Bond (LSBRX)

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PORTFOLIOS FOR SAVERS AND RETIREES

Retirement saver

PORTFOLIOS

nvestors who watch a lot of Ànancial television might assume that the key to successful portfolio management is constant activity, all with an eye toward staying a step ahead of the crowd. If everything lines up in your favor, you can come out ahead. But fast-trading strategies can be costly, too. Not only do too-active investors incur higher trading (and potentially tax) costs than more hands-off investors do, but very active investors also subject themselves to the costs of bad timing. Investors crowded into bond funds in the years following the Ànancial crisis, for example, when in reality they should have been rebalancing back into stocks, which went on to soar. Because bad timing can eat into returns, Morningstar generally counsels a handsoff, long-term approach to portfolio management. In contrast with the market-timing investor who jockeys in and out of the stock market, the long-term investor Ànds a sensible asset mix given his or her proximity to needing his or her money, then makes only gradual adjustments, periodically rebalancing and making his or her asset mix more conservative as the years go by. Patience, discipline and sturdy core investments — rather than sharp timing acumen — are the keys to making the long-term approach

work. In 2014, Morningstar developed hypothetical “Saver” portfolios designed for investors who are still working and accumulating assets for retirement. All of the portfolios use Morningstar’s Lifetime Allocation Indexes to determine their asset allocations and are populated with funds that are favorites among Morningstar’s analysts. Shared here is the series composed of traditional mutual funds featuring aggressive, moderate and conservative asset-allocation mixes. An alternative route would be to use inexpensive index-tracking mutual funds or exchange-traded funds in lieu of the actively managed funds in these portfolios. Investors can adopt the portfolios wholesale, but perhaps the greater beneÀt is as a check on their asset allocations and investment choices. While investors may ultimately choose to customize their portfolios based on individual-speciÀc factors — some of which are outlined here — the portfolios aim to provide investors with a “sanity check” for their own portfolios’ asset allocations.

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Aggressive Retirement Saver Portfolio

Moderate Retirement Saver Portfolio

The Aggressive Retirement Saver mutual fund portfolio uses the allocations of Morningstar’s Lifetime Allocation 2055 Aggressive Index to guide its weightings. That means it’s geared toward younger, risk-tolerant investors who expect to retire in or around the year 2055. That index devotes more than 90 percent of its assets to stocks, so anyone considering such a portfolio should not only have a long time horizon but should also be able to tolerate the volatility that can accompany a very high stock allocation.

The Moderate Retirement Saver Portfolio uses the allocations of Morningstar’s Lifetime Allocation 2035 Moderate Index, which has about 81 percent of assets in stocks.

20%: Primecap Odyssey Growth (POGRX) 20%: Oakmark Fund (OAKMX) 15%: Diamond Hill Small-Mid Cap (DHMIX) 30%: Vanguard Total International Stock Index (VGTSX) 7%: T. Rowe Price International Discovery (PRIDX) 3%: Metropolitan West Total Return Bond (MWTRX) 5%: Harbor Commodity Real Return (HACMX)

For its core U.S. stock exposure, the portfolio relies on Primecap Odyssey Growth and Oakmark Fund. The Primecap fund generally aims to buy high-growth companies that are temporarily selling at bargain prices, while the latter employs a more traditional value strategy. The portfolio includes exposure to smaller companies thanks to Diamond Hill SmallMid Cap. It also stakes more than a third of stock assets in foreign-stock funds: a broadly diversiÀed offering, Vanguard Total International Stock Index, as well as one devoted to small and midsize Àrms overseas, T. Rowe Price International Discovery. Both funds include a sizable complement of emerging-markets equities. Due to all of these characteristics — a slight tilt toward small- and mid-caps and a large foreign- and emerging-markets weighting — the portfolio has an aggressive cast. As such, we would expect it to perform better than the broad market during strong stock-market environments and worse on the downside.

15%: Primecap Odyssey Growth (POGRX) 15%: Vanguard Dividend Growth (VDIGX) 15%: Oakmark Fund (OAKMX) 10%: Diamond Hill Small-Mid Cap (DHMIX) 21%: Vanguard Total International Stock Index (VGTSX) 5%: T. Rowe Price International Discovery (PRIDX) 14%: Metropolitan West Total Return Bond (MWTRX) 5%: Harbor Commodity Real Return (HACMX)

There are a couple of noteworthy differences between the Aggressive and Moderate portfolios. First, the Moderate portfolio’s stock allocation is a touch lower — 81 percent versus more than 90 percent for the Aggressive portfolio. That differential owes to the Moderate portfolio’s lighter international stock allocation; the domestic-stock stakes in both portfolios are virtually identical in size. However, 40-somethings with high risk tolerances — that is, those who didn’t freak out and sell during the global Ànancial crisis — could reasonably keep their total stock weightings as high as 90 percent. We also tweaked the domestic-stock slice of the Moderate portfolio slightly, to give it a higherquality tilt. We added a stake in Vanguard Dividend Growth, in addition to Oakmark Fund and Primecap Odyssey Growth, to give the portfolio a higher weighting in true blue chips and dividend-paying names. In addition, we reduced the portfolio’s smallcap exposure via Diamond Hill Small-Mid Cap and T. Rowe Price International Discovery, albeit just slightly.

Conservative Retirement Saver Portfolio The Conservative Retirement Saver portfolio — geared toward still-working individuals who expect to retire in 2020 or thereabouts — maintains a more than 50 percent weighting in stocks. That’s lower than the stock positions in the Moderate and Aggressive Saver portfolios, but it’s higher than many pre-retirees might expect. 10%: Primecap Odyssey Growth (POGRX) 10%: Vanguard Dividend Growth (VDIGX) 10%: Oakmark Fund (OAKMX) 7%: Diamond Hill Small-Mid Cap (DHMIX) 10%: Vanguard Total International Stock Index (VGTSX) 4%: T. Rowe Price International Discovery (PRIDX) 30%: Metropolitan West Total Return Bond (MWTRX) 7%: Fidelity Short-Term Bond (FSHBX) 7%: Vanguard InÁation-Protected Securities (VIPSX) 5%: Harbor Commodity Real Return (HACMX)

For the Conservative Retirement Saver portfolio, we targeted a 37 percent allocation to U.S. stocks, and 14 percent to overseas stocks. For stock exposure, we held on to the same funds employed in the Moderate Saver portfolio, albeit in smaller allocations. Because the bond piece of the Conservative Retirement Saver portfolio — 44 percent of total assets — is larger than is the case with the Moderate Saver portfolio, it’s also more nuanced. While younger accumulators can get away with a single well-diversiÀed bond fund — say, a core intermediate-term bond fund — people closing in on retirement will want to start diversifying their bond exposure. Thus, the Conservative Retirement Saver includes Treasury InÁation-Protected Securities (TIPS) to help preserve purchasing power in the enlarging bond portfolio; we used the low-cost Vanguard InÁation-Protected Securities (VIPSX). (Treasury InÁation-Protected Securities are bonds whose principal values adjust upward as inÁation, as measured by the Consumer Price Index, ticks up.) Individuals at this life stage might also start setting up their portfolios by anticipated income needs, as demonstrated with the bucket approach to retirement income, which is discussed at length elsewhere in this guide. With retirement Àve 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 bond sleeves to a short-term bond fund that could be readily converted into cash. After all, having sufÀcient 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. It’s not too early to start lining up fairly liquid investments to meet income needs in the early years of retirement — in case income and rebalancing proceeds are insufÀcient to fund living expenses and the market is in the dumps. Q

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