Financial Makeover: Making Up for Lost Time

By Christine Benz, ( Morningstar)

CHICAGO ( Morningstar) -- At first blush, Scott's goal of an early retirement appears to be out of reach. At age 48, this former military serviceman would like to find a way to retire in 10 years, having done several tours of duty in the Middle East. He has begun to save at an aggressive rate, and to date he has amassed $173,000. That's not small change, but it's not enough to fully fund a retirement that could last three decades or more.

Scott is a lot closer to hitting his goal than it might seem, though. One big benefit of his military service is that he's already drawing upon a pension paying $71,000 per year; that amount will be adjusted to keep pace with the Consumer Price Index. In addition, he's working in a U.S. government job; from that position, he will get a pension generating an additional $15,000 per year when he becomes eligible for it at age 56. The $86,000 in combined pension income doesn't meet Scott's target income level of $120,000 per year, but it does mean his income demands from his portfolio are a fairly modest $34,000 per year. When Social Security for Scott and his wife is factored into the income mix, Scott's income demands from his portfolio are lower still.

Veterans
A former military serviceman is fast on his way to being able to retire in 10 years.

The fact that Scott's pension covers a large share of his current living expenses has a beneficial side effect for his retirement kitty, too: It means he can save aggressively for retirement in the years ahead. Scott notes that he saves $5,000 per month in his taxable brokerage account and Roth IRA, and puts another $1,570 per month into the Thrift Savings Plan, a defined-contribution plan for federal workers. By saving roughly $80,000 per year, Scott should be able to bulk up his portfolio in short order, even without the benefit of robust market returns.
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The before portfolio
Scott's portfolio features a fairly conservative asset-allocation mix: 42% in stocks, 28% in bonds and 27% in cash. Another 2% of the portfolio, largely convertible bonds, lands in the "other" bucket.

He holds his assets in a few different silos, such as a Roth IRA, a taxable brokerage account and the government TSP. His Roth and taxable accounts amount to about three-fourths of his total assets, with the remainder in the TSP.

Scott noted that he's a fan of my colleague, Morningstar's ( MORN) resident dividend guru Josh Peters, and his fondness for income comes through loud and clear when I asked Scott to describe his investment philosophy. "My intent is to patiently build a dividend-growth portfolio and a quality-fund portfolio that will grow to provide the principal needed to generate the income I would like to have to maintain my family's quality of life," he wrote.

Not surprisingly, his taxable and Roth portfolios contain individual dividend-paying stocks, such as Abbott Laboratories ( ABT) and food distributor Sysco ( SYY) as well as income-focused stock/bond and hybrid funds. Templeton Global Bond ( TGBAX) and BlackRock Muni Holdings Investment Quality ( MFL), a leveraged closed-end fund, are among Scott's largest individual holdings.

Within the TSP, where the only options are plain-vanilla index funds with very low costs, Scott can't help but keep it simple. His largest position is in the G fund, which provides a compelling risk/reward profile unavailable in the realm of retail funds -- a yield in line with long-term Treasuries along with guaranteed stability of principal. He also has smaller positions in an S&P 500 index tracker (the C fund), an extended market index fund (the S fund), and an international index fund (the I fund). (I wrote about the government's Thrift Savings Plan last year.)

The after portfolio
Nearly all of Scott's holdings possess good Morningstar Ratings for stocks or funds (though a handful aren't under coverage). I'm also impressed by his well-reasoned investment approach and the discipline with which he adheres to it. More important, his portfolio appears to be on track to meet his income needs in 10 years. Plugging his portfolio into Morningstar's Asset Allocator tool, Scott's portfolio is on track to deliver his income goal of $34,000 for 30 years, even without factoring in his Social Security benefit.

I have a few ideas for making a portfolio such as Scott's even better, though. For starters, the portfolio's large cash stake -- 27% of the portfolio at last count -- translates into a high opportunity cost given skimpy yields and the prospect of higher inflation, particularly given that Scott has no imminent need for cash beyond a minimal emergency fund. Scott notes that his cash hoard is there so he can buy on the dips: He wrote, "I use the cash reserve to purchase income-producing investments at reasonable valuations (hence the patience part), to dollar-cost average into some select funds and to bulk-purchase buckets of funds if valuations are low."

That strategy is common to many great investors, from Benjamin Graham to Jean-Marie Eveillard. Until the bargains present themselves, however, Scott could consider wringing out a higher yield by moving at least half of his cash holdings into a high-quality short-term bond fund: T. Rowe Price Short-Term Bond ( PRWBX) is a Morningstar favorite. That bumps up the portfolio's bond stake, and in turn its interest-rate sensitivity, but not to a huge extent.

Against an uncertain bond-market environment, I like the go-anywhere flexibility that funds such as Metropolitan West Total Return Bond ( MWTRX) and DoubleLine Total Return ( DLTNX) have. And because those two funds focus primarily on corporate and asset-backed bonds, they're a nice complement to the G fund, which concentrates on U.S. government bonds. By enlarging the positions in those two names and making other changes, I excised the positions in two closed-end municipal-bond funds: BlackRock Muni Holdings Investment Quality and Nuveen Dividend Advantage Muni ( NZF). Closed-end fund analyst Cara Esser says that both funds look decent and notes that Morningstar's CEF analyst team particularly likes Nuveen's closed-end lineup. But I prioritized making room for additional holdings over retaining these two.

One such addition was explicit inflation protection via Treasury Inflation-Protected Securities. Dollar-cost averaging into a fairly small position in a TIPS fund such as Harbor Real Return ( HARRX), Vanguard Inflation-Protected Securities ( VIPSX), or the ETF iShares Barclays TIPS Bond ( TIP) would be a straightforward way to do so. Additional inflation protection falls into the category of "nice to have" rather than "must have" for Scott, however, because his pension will step up with inflation.

One other notable feature of Scott's portfolio is its relatively small average market cap. At $16 billion, it's just one-third of the S&P 500's, even including Scott's sizable position in an S&P 500 index tracker. Given that large stocks are arguably more attractively valued than small- and midcap names right now, boosting exposure to large names could prove to be a timely move. Much like Dividend Growth Trust Rising Dividend ( ICRIX), Vanguard Dividend Appreciation ( VIG) focuses on companies with a history of raising dividends. But it has lower expenses and a higher yield and also provides greater exposure to mega-cap companies. (For an actively managed alternative with a similar thrust, check out Vanguard Dividend Growth ( VDIGX), which puts an even greater emphasis on mega-caps.) Assuming Scott would like to retain the exposure to the master limited partnerships that Dividend Growth Rising Dividend brings to the table, he could consider a slice of the JPMorgan Alerian MLP Index ( AMJ), an exchange-traded note that tracks a basket of MLPs. (Scott also owns MLPs directly via Energy Transfer Equity ( ETE).)

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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.
Data are as of May 18. 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.