Building a Retirement Portfolio with Mutual Funds


This is part of a series of posts for an online class on how to use your investments to fund your retirement.  To find other posts in the series, select the category  “Retirement Investment Class” under “Retirement Investing” at the top. 

Let’s say that you have $2M saved up in your 401k and are ready to retire.  Let’s also say that you need about $50,000 per year to live on the first year, with that amount growing with inflation each year.  Today we’ll discuss how you would use a set of mutual funds to to generate the income that was needed while keeping up with inflation to avoid outliving your money.

The rule-of-thumb is that you can withdraw somewhere between 3% and 4% of your portfolio each year and have a very good chance of having it last through a 30-year retirement.  In fact, the balance could grow under a lot of scenarios.  Withdrawing $50,000 per year from a $2M portfolio would therefore be right in line  with the guidance, since you could withdraw about $60,000 per year and stay at the low end of the range.  You have done well saving and investing throughout your career to put yourself in good shape for retirement.

Ideally you would generate a lot of the income you need for expenses from income producing assets.  You would therefore put a portion of your portfolio in an income or a bond portfolio.  You would also want a portion of the portfolio to grow and keep up with inflation, so you would want to invest the rest in growth and value stock funds.

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We’ll use Vanguard funds as an example.  Looking through their list of funds for income funds, I find the Vanguard Total Bond Market Index fund.  This is a fairly safe fund, although the price could decline if interest rates rise or a serious recession occurs that causes several companies to default on their loans.  In general, as long as I planned to hold this fund regardless of interest rate changes such that price drops due to rising interest rates would not be an issue, chances are good that I would not have any issues.

It is described at the Vanguard website as:  “This fund is designed to provide broad exposure to U.S. investment grade bonds. Reflecting this goal, the fund invests about 30% in corporate bonds and 70% in U.S. government bonds of all maturities (short-, intermediate-, and long-term issues). As with other bond funds, one of the risks of the fund is that increases in interest rates may cause the price of the bonds in the portfolio to decrease—pricing the fund’s NAV lower. Because the fund invests in all segments and maturities of the fixed income market, investors may consider the fund their core bond holding.”

This fund is yielding about 2.5%, so a $1M investment would be paying about $25,000 in interest each year, plus a capital gain from time-to-time.

There is also the High Yield Corporate Bond fund, which is paying about 5.1%, or about $51,000 per $1M invested.  This fund is more risky since the bonds it is investing in are low quality, meaning the companies would be more likely to default than they were with the first fund.  During a recession, I would see some bigger losses in this fund, so I would want to limit my exposure despite the higher yield.  It is described at the Vanguard website as:

“Vanguard High-Yield Corporate Fund invests in a diversified portfolio of medium- and lower-quality corporate bonds, often referred to as “junk bonds.” Created in 1978, this fund seeks to purchase what the advisor considers higher-rated junk bonds. This approach aims to capture consistent income and minimize defaults and principal loss. Although this is a bond fund, high-yield bonds tend to have volatility similar to that of the stock market. This fund may be considered complementary to an already diversified portfolio.”


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I would also look at REITs, which invest in real estate and also generate a reasonable cash return due to the properties in which it invests.  The Vanguard Admiral REIT fund is described as:

“This fund invests in real estate investment trusts—companies that purchase office buildings, hotels, and other real estate property. REITs have often performed differently than stocks and bonds, so this fund may offer some diversification to a portfolio already made up of stocks and bonds. The fund may distribute dividend income higher than other funds, but it is not without risk. One of the fund’s primary risks is its narrow scope, since it invests solely within the real estate industry and may be more volatile than more broadly diversified stock funds.”

It is yielding about 4.3%, or $43,000 per year for a $1 M investment.  REITs would move around a bit since their value depends on the value of the properties it holds, rents they can charge, and other factors.  This portion of the portfolio would also have a growth component since the property values would increase with inflation and as fewer properties were available to buy for a growing population.

You would want your investment mix to be maybe 50% income, 50% growth at 65 years old, so that would leave $1M to invest among these three funds.   I would probably put 50% in the safer bond fund, 25% in the junk bond fund, and 25% in the REIT fund.  This would result in an income of:

Total Bond Fund: $500,000 invested, income $12000/year

High Yield Bond Fund:  $250,000 invested, income  $13,000/year

REIT Fund: $250,000 invested, income $11,000/year

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Your total income would therefore be about $36,000 per year, so you would be about $14,000 per year short of your income goal.  The remainder would need to come from selling stocks off each year, plus a little bit of income from dividends.  For stocks I would look at the Large Cap Index Fund, which is paying out about 1.8% per year, the Small Cap Index Fund, which is paying out about 1.4%, and the Total International Index fund, which is paying out about 2.8%.  With the remaining $1M I would put about 25% in the international fund, and then put 50% in the large cap fund and 25% in the small cap fund.  This would generate income as follows:

Total International Fund:  $250,000 invested, income $7,000 per year

Large Cap Index: $500,000 invested, income $9,000 per year

Small Cap Index:  $250,000 invested, income $3500 per year

So your total income from your stock portfolio would be about $19,500 per year.  Summed together with your bond portfolio, this would equal $54,500 per year in income.  Because you are actually generating more income than you needed, you could either reinvest a portion of the income each year into stocks or bonds.  You could also cut your bond exposure a little and let more of your money grow at the faster, stock market rates.  You could expect a growth rate of about 8% on average from your stocks.

 

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Have a burning investing question you’d like answered?  Please send to vtsioriginal@yahoo.com or leave in a comment.

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Disclaimer: This blog is not meant to give financial planning or tax advice.  It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA.  All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

Retirement Investing Choices: Annuities


This is part of a series of posts for an online class on how to use your investments to fund your retirement.  To find other posts in the series, select the category  “Retirement Investment Class” under “Retirement Investing” at the top. 

Now that we’ve discussed how much you need to save for retirement and provided some information on mutual funds and ETFs, we can start to discuss some of the different investment options for your retirement portfolio and their role in the big picture of things.  Today we’ll start with an asset called an annuity.

An annuity is an income vehicle issued by an insurance company.  In exchange for turning over some of your money to the insurance company, they agree (guarantee) to pay you a specified amount of money for a specified period of time, which could be the rest of your life.  Because annuities are insurance contracts, there are all sorts of different types, limited only by the insurance company’s creativity in designing a product they hope they’ll buy.

The main benefit of an annuity is the guaranteed income.  That guarantee comes at a price, however, in that the income you receive will be less than the income your money could have generated if you had invested it on your own.  They should therefore be used when security is more important than return, or if you simply don’t want to fool with things and are willing to accept less in exchange for your time and effort.  Annuities are a fix-it-and-forget-it type of investment.

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The most basic type of annuity, called an immediate annuity, simply pays you a specified amount of money starting immediately for a prescribed period of time, often the rest of your life.  For example, let’s say that you buy an immediate annuity at age 70, giving the insurance company $1 M.  They may in exchange give you $4,166 per month, or $50,000 per year, for the rest of your life.  If you live to age 90, you would then have collected $1 M back from from the policy.  If you live to age 100, you’ll have collected  $1.5M.

All policies are different, so you should read the terms carefully, but many policies would simply keep your original $1 M investment when you died.  So if you die at age 71, you would have only receive $50,000 back from the insurance company for the $1 M you gave them.  They would make out very well on the policy.  This makes up for the people who live to age 100, and is the nature of insurance – they make lots of money from some policies to make up for the others where they lose money.  Some policies might reimburse your heirs a portion of the investment if you die before a certain age, but this is not a certainty.  Again, the are contracts between you and the insrance company and can all be different, so you should carefully read and understand the terms (and maybe have an attorney or CPA read the policy as well) before you buy anything.

 

Another popular type of annuity doesn’t pay right away, but instead starts to pay when you reach a specified age in the future.  These are useful if you’re worried about running out of money later in life.  For example, at age 50 you could buy a policy that starts to pay you a monthly amount at age 80.  The earlier you buy these policies, the less they cost for a given pay-out (since you’re taking a chance that you’ll never reach that age, plus you’re letting the insurance company use your money for all of those years).  These can be a very useful way to guarantee that you won’t be destitute should you live a long time.  They are also relatively inexpensive since there is a real possibility the insurance company may get to keep the money and never pay out anything.  The later in life the policy starts pa, the less it should cost.

While there are limited exceptions (insurance companies spend a lot of money doing calculations and making sure that they come out ahead), on average you’ll not do as well with an annuity as you would have had you invested on your own.  While you might be taking some of the insurance company’s money if you live to age 100, most people will not live past 85 or 90.  Taking the same example of a $1 M nest egg described above, if you had invested the money instead of buying an immediate annuity, a properly designed portfolio of stocks and bonds should allow you to withdraw about $30,000 – 40,000 per year for the rest of your life, indexed for inflation, without ever touching the principle.  This means you could have withdrawn about $1,050,000 between the ages of 70 and 90 and still have had $1.6 M to leave to your kids when you died.  This is compared to receiving $1 M from the annuity and having nothing to leave your kids.

If you lived to age 100, you’d have withdrawn about $1.8 M from the portfolio, versus receiving $1.5 M from the annuity, and now have $2 M to leave to your kids (which will buy what $1 M buys today).  Investing on your own, instead of buying an annuity, will generally result in you both receiving more income while you are alive and in you having more money to pass on to your kids.

So, with an annuity, you’re trading risk – the risk that you won’t invest well or that the markets just won’t cooperate – in exchange for giving up some return on your money.  The insurance company now takes on this risk and needs to find ways to invest the money to ensure that they have enough money to pay the policy holders while still making a reasonable profit.  They set their pay-outs in such a way to make sure that they cover this risk, on average, just like how set their car insurance rates high enough to cover claims and still make money.  The amount they pay is also generally fixed (for example, $50,000 per year), so your spending power will decrease over time due to inflation.

You may worry that an insurance company may charge you way too much for an annuity, resulting in a huge profit for them, but market forces should generally take care of this for you as long as you do your part and compare products from several different providers to get the best deal.  As long there are enough insurance companies out there competing for your business, you should get the maximum return possible with the insurance company making just enough money on your policy to pay the person who sold it to you, keep the lights on, and make a reasonable profit for their shareholders.  You’ll still be paying for all of this overhead, but that is what you are trading for the security of a monthly payment instead of the less unpredictable returns from an investment portfolio.  Just make sure you do your part and shop around for the best return, since once you buy in it is expensive to undo the deal, even when you can.

Realize also that people selling annuities to you generally make a commission from the sale, which both adds to the cost and makes them eager to sell you something, even if it isn’t the best thing for you.  Many of these salesmen know little about what they’re selling.  They just know what they’ve been told to tell you to get you to buy.  In general the choice to buy an annuity should be yours, not the result of a high-pressure sale, and you should take the time to read the policy and review it with whatever professionals you need to make sure you’re making a good decision.

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Some annuities also make offers of additional potential returns based on the stock market or come with other bells and whistles. While this may sound enticing, you’ll do better just buying a smaller annuity and investing the rest of the money yourself.  Remember that the insurance company needs to make money, so the returns they’ll provide will be well lower than market returns.  Only buy annuities when you want a guaranteed return, not as a way to invest in the stock market.

Finally, know that the guaranteed return from an annuity is only as good as the insurance company who you buy the policy with (and whomever they sell it to).  If we see another Great Depression, it is very likely that the insurance companies would all go broke and leave policy holders in the lurch.  Because they need to invest the money in the markets themselves, if most businesses are going bankrupt, they would not have the money to pay out the payments each year in a collapsing market.  Note that the supposed “great recession” was nothing like the Great Depression.  Luckily such market events happen fairly rarely.

Have a burning investing question you’d like answered?  Please send to vtsioriginal@yahoo.com or leave in a comment.

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Disclaimer: This blog is not meant to give financial planning or tax advice.  It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA.  All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

What Are Growth and Value Funds?


This is part of a series of posts for an online class on how to use your investments to fund your retirement.  To find other posts in the series, select the category  “Retirement Investment Class” under “Retirement Investing” at the top.  The posts will appear in reverse order, with the newest post first. 

In the last post in this series, How to Evaluate Mutual Funds and ETFs, we briefly talked about the Style Box.  Today we’re going to go into a lot more depth on how to use this useful little tool for evaluating mutual funds and the concepts behind it.  This is one of the most important topics for determining how to determine your asset allocation.  Get this right and you’ll gain a couple of percentage points of return each year, which will translate into millions of dollars in a retirement account held over four decades or more.  It is still important in retirement investing as well, although how you allocate your money will be somewhat different.

Today we’ll discuss the style box typically used for stock mutual funds.  Bond funds use one as well, although the categories would be different.  A sample stock fund style box, taken from the description of one of Schwab’s mutual funds, is shown below.  On the bottom, horizontal axis, the investment style is shown, going from Value to Growth investing.  In the middle is Blend, which just means it is a combination of both Value and Growth investing.  On the vertical axis is the market cap, including small, mid, and large cap.  We’ll go over each of these categories.

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Investment Style

There are two main styles of investing, both of which have been applied successfully and both of which work well at different times.  The first is value investing, which is based on what is known as the Firm Foundation Theory.  The Firm Foundation Theory says that a stock has an appropriate price, or value, based upon the fundamentals of the company.  Stocks that have a price exceedingly below this value are considered inexpensive and likely to increase in price, while those that are priced way above this value are considered high in price and likely to decline back to the appropriate value.

People who are value investors would look at earnings, property, and the prospects for future earnings and determine a value for the company.  They might, for example, look at the price/earnings ratio, or PE, which is the price of the stock divided by earnings per share.  They would compare the PE value to both the historic range of values for the company and to the PE ratios of other companies in the same line of business.  They would seek to buy stocks that have a low PE, meaning that they are cheap compared to their value, and sell stocks they hold that have a high PE, meaning that they are expensive compared to their value.

Growth Investing involves finding stocks in companies that are growing rapidly and buying their shares.  This often involves finding the stocks that are reaching all-time highs and buying their shares, relying on the momentum of the company’s share price to continue.  Growth investors would look at things like earnings and dividend growth rate, the number of new stores that are being opened or the potential size of new business lines a company is creating.  They would tend to buy smaller companies that have potential to grow, shying away from companies like WalMart and McDonald’s that have already expanded greatly and would have difficulty doubling their earnings.

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Often value investors are buying stocks in companies that are having financial issues, which makes value investing slightly more risky than growth investing since some of the companies they’ll buy will not be able to turn things around and go bankrupt.  Growth investing also has a risk, however, since sometimes companies grow too fast, taking on debt while they do so, and end up needing to sell off assets and restructure. Growth investors are also buying shares of stock when they have already gone up in price, hoping that they will continue to go up, so they sometimes overpay for them.  Over the history of the US markets, value investing has outperformed growth investing on average but not always.  An exception is the period from 1980 through 2000, during which time growth was king.  Growth also outperformed value from 2008 through 2016, although value has done better during this last year.

Market Cap

Market cap, or market capitalization, is how large a company is.  Market cap is found by multiplying a stock’s price per share by the number of shares outstanding.  Small cap companies obviously have small market values, while large caps are huge enterprises like Home Depot and Google.  Small caps have more room to grow, given their small size, which means that they have a lot of growth opportunities, but large caps have the ability to get better pricing through concessions from vendors, as well as the ability to weather downturns by expanding into multiple business lines and/or parts of the world.  Mid caps fall between the nimble small companies and the Fortune 500 companies, but should be thought of as an extension of small caps since they tend to perform similarly.

Over long periods of time, small caps will outperform large caps since they have more room to grow.  The exception is turn-around companies that shed a lot of the old baggage and in a sense become new companies again.  During any given 10-year period small caps may outperform large caps, or large caps may outperform small caps, so you can never really be sure about which asset class would make the better investment.  If I were buying and holding for a 40-year period and had to choose one, I would buy small caps since they would grow more than large caps and outperform.  If I were holding for a 10-year period, however, I would probably choose large caps since they would likely hold up better should a business downturn occur since they have more cash reserves and financial stability.

 

Setting up a Portfolio

Now that we’ve discussed the style box and the different investing styles and market capitalizations, how does an investor put this to use?  In setting up a portfolio, you’ll  want to cover the full spectrum of investing styles and company sizes.  You don’t know which style and company size will perform best during any given period, so you want to invest in everything to make sure you are in the sector that is doing the best at any given time.  This means that you’ll never have all of your money in the sector that does the best and make the maximum possible returns, but it also means that you’ll never be entirely in the sector that is doing the worst and miss out on a good rally or bear the brunt of a big decline.  There is no way to know which sector will do the best over the next year or ten years, and attempting to guess will normally cause you to underperform the overall markets, so it is better to accept that some portions of your portfolio will always do worse than others in exchange for always having at least some of your money in the hot sector at any given time.  Just realize that those that lag now will probably lead in the future.

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So, you’ll want to buy funds that either cover the four corners of the style box or buy both small cap and large cap blended funds that include both growth stocks and value stocks.  You can also buy mid-cap stocks to further diversify your holdings.  You can also cover everything by buying a total market fund, which basically invests in everything, all in one fund.

If you are young, because value will outperform growth over long periods, and small caps will outperform large caps over equally long periods, you may want to skew your holdings slightly into these areas if you have decades to wait.  In doing so you’ll probably slightly outperform an evenly split portfolio, but not by much.  This becomes more important the longer the time period over which you are investing since small differences only add up to big money over long periods of time.  For those already in retirement, however, it is better to either split things evenly or even skew more to the large cap side due to their larger dividends and stability.  In the next post we’ll provide model portfolios based on these ideas and show how this is done.

Have a burning investing question you’d like answered?  Please send to vtsioriginal@yahoo.com or leave in a comment.

Follow on Twitter to get news about new articles.  @SmallIvy_SI

Disclaimer: This blog is not meant to give financial planning or tax advice.  It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA.  All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.