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Makeover Matures Younger Retiree's Portfolio

The after portfolio
Job one for new retirees such as Susan is to take a close look at projected in-retirement living expenses and use that number to determine the viability of their portfolios to cover their income needs during retirement. I used Morningstar's (MORN - Get Report) Asset Allocator tool as a starting point for this analysis, taking into account projected income needs of roughly $85,000 per year, assuming a 40-year time horizon, and plugging in a more conservative asset allocation than Susan has now (40% in cash and bonds and the remainder in stocks).

The good news is that Susan's nest egg appears well-positioned to support her income demands in retirement, even accounting for a $100,000 down payment for her townhome. Based on Asset Allocator's projections, her portfolio has a 99% likelihood of lasting throughout her retirement years.

Susan's anticipated annual cash needs also provide a good starting point for creating a more age-appropriate asset-allocation framework. Because it's so intuitive, I'm a fan of the so-called bucket approach to staging retiree portfolios, creating separate pools of assets for short-, intermediate- and long-term time horizons.

For an investor such as Susan, bucket No. 1 would consist of enough cash to cover living expenses during the next two years as well as any sums needed for big planned purchases, such as real estate. (If Susan decides to buy a townhome outright rather than taking a mortgage, she'd likely need to set even more cash aside.) Assuming living expenses of $85,000 a year and another $100,000 for a down payment, the cash stake would weigh in at roughly $270,000. Cash yields are paltry, but given the near-term need for this money, it shouldn't be subject to short-term fluctuations.

Bucket No. 2 would consist of intermediate-term assets earmarked to cover living expenses for years three through 10 of retirement -- roughly $700,000 ($85,000 per year times eight years). With this part of the portfolio, an investors such as Susan could consider taking a step out on the risk spectrum beyond cash, encompassing bonds of varying types and maturities. Susan's fixed-income holdings, DoubleLine Total Return (DLTNX) and Artio Global High Income (BJBHX) , are good starting points for this sleeve of a portfolio, but these holdings could be diversified further with positions in T. Rowe Price Short-Term Bond (PRWBX) , Harbor Bond (HABDX) , Loomis Sayles Bond (LSBRX) and Harbor Real Return (HARRX) .

Bucket No. 3 would consist of longer-term assets, those earmarked for years 11 and beyond of retirement. For this portion of a portfolio, many of Susan's existing holdings are perfectly worthwhile. Core equity positions, including Harbor International, T. Rowe Price (TROW - Get Report) Small Cap Value and Amana Trust Growth, could be retained. But to help raise money for her new bond holdings, Susan could streamline some of her small- and midcap holdings, some of which are duplicative, and concentrate her assets in her highest-conviction names. Although Susan says she has confidence in the ability of active managers to outperform and, importantly, in her own ability to hang on through periodic rough patches for their investment styles, my after portfolio includes some index-fund and exchange-traded fund exposure. The goal of the addition of index funds was twofold: to lower the overall portfolio's expense load and to ensure adequate style and sector diversification.

How to approach the makeover
Execution is a key consideration for this (and any other) portfolio makeover. Susan's target allocation calls for a much higher weighting in bonds than she had before, but with a possible bump-up in interest rates during the next few years, it makes sense to enlarge such a portfolio's bond position gradually during the next several years rather than all at once. Doing so will help ensure she gets a range of purchase prices for her bond holdings.

Investors such as Susan should also pay attention to asset location as they reposition their portfolios. Younger retirees must remember that they can't begin withdrawing from IRAs until age 59.5, so they'll want to keep cash in taxable accounts. At the same time, it is important to be mindful of the tax costs of holding bonds and other income-producing assets in taxable accounts. In the after portfolio, I tried to strike a balance between tax efficiency and ease of access to money for living expenses; my after portfolio holds some of the highest income producers in the tax-sheltered slots, while stashing lower-income-producing bond funds in the taxable account.

Finally, young retirees such as Susan should develop a strategy for tapping Social Security. If they think they have longevity on their side, it may pay to defer receipt of Social Security beyond their normal retirement age -- as late as age 70. This article details some of the key considerations to bear in mind when making this important decision.

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-- Written by Christine Benz, director of personal finance for Morningstar in Chicago. Benz is also editor of Morningstar Practical Finance, a monthly personal-finance newsletter, and writes a weekly column on Morningstar.com.
Please note that the information above is not intended to be personalized portfolio advice for the makeover subject or any other investor. It is meant to illustrate a common investor dilemma and offer general portfolio ideas for consideration by investors in similar circumstances. Every investor's situation is distinctive and may include several important variables not accounted for in this makeover.
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