NEW YORK (Money magazine) -
A member of my family recently asked me for financial advice.
The specifics of his situation are unique, but the basic problem is fairly common: how to invest limited retirement savings and make the money last.
Although my relative earned a hefty income at some points during his life, he never had access to a pension plan or a 401(k). After he retired, he was left with his Social Security and relatively limited investments beyond the equity in his home.
He finally sold his house, and after paying off the mortgage, he had about $225,000 to invest. He first considered buying an annuity, but the returns were too low. Then he asked if I could recommend a better alternative. Here's what I wrote him.
I'm glad the sale of the house went well, and I'd be happy to help you explore your investment options. Frankly, it's not surprising that the annuities you investigated offered inadequate returns.
The real selling points of annuities are safety and predictability, not high pay outs. And you're going to have to stretch a little bit to reach the targets you've set. You want to withdraw about $2,000 a month -- or $24,000 a year -- from investments totaling around $225,000. That requires a 10.7 percent annual return if you spend only interest, dividends and capital gains but leave your principal completely untouched.
Fortunately, you can afford to spend a little principal -- 2 percent a year, say -- as long as you don't run through it fast. Realistically, that means you need to achieve an average annual return of 9 percent or so, which is doable without taking huge risks.
But conservative income investments won't be enough to get you there. You'll also need some stocks that offer long-term growth.
The backdrop of war and possible further terrorism makes the investment outlook even more uncertain than usual. Still, the worst appears to be over for the market. Low interest rates and massive government spending should stimulate the economy.
Trends in both corporate revenue and earnings are slowly improving, despite scattered disappointments. Most important, high-quality stocks are no longer wildly overpriced. From today's levels, stocks should be long-term winners, even if they perform badly in a given quarter.
You've already told me that you are comfortable putting at least half of your money in stocks, even if those investments are volatile. But be sure you are willing to ride out short-term setbacks.
Would you really be okay if some of your investments dropped by 30 percent and needed more than a year to recover? The investments I suggest should be comparable to or less volatile than the overall market, but even conservative choices can decline in value.
Before I get to specific investment picks, let me walk through the logic.
The concept. It's possible to achieve financial goals by choosing a single investment or a small group of similar investments. But history shows that you can attain higher returns with lower risk through a strategy known as asset allocation. This consists of dividing money among a variety of different investments that collectively provide the optimum mix of risk and return, even though some of the choices may seem inappropriate when considered individually.
The means. It is most practical for you to rely on mutual funds. Buying individual stocks and bonds takes more money than you have right now and also requires active management and considerable record-keeping for tax purposes. Mutual funds, by contrast, provide diversification because they generally own several dozen different investments. In addition, they require relatively small minimum initial investments. They can provide monthly distributions and do much of the record keeping for you.
Minimizing risk. The plan I'm proposing has a number of characteristics that minimize risk. In addition to diversifying among types of investments, it also spreads your money among several financial institutions that are all large and well-regarded. In addition, the specific funds offer a favorable balance between volatility and potential gains. There's a limit to how much return you can reach for and still meet your requirement that risk be held to a minimum. But at least half the funds in the package offer real growth potential.
The portfolio. The package rests on nine funds divided into three groups of three. Each group balances the other two. You should plan to invest an equal amount -- $25,000 -- in each fund, although not necessarily all at once. All of the funds discussed charge lower-than-average annual fees -- in several cases, much lower. Here's a look at the specific picks, starting with the income group because it's the safest.
Keep the first $25,000 in your bank's money-market fund. Such a fund is almost completely safe, but its yield is very low, less than 2 percent. Right there is the catch. Keeping your principal completely safe creates an even greater risk -- that you will earn so much less than you need that your money will run out. To protect your principal over the long term, it's smarter to take the risk of some short-term volatility.
You can get higher yields on your income investments by adding a couple of funds that hold bonds or other long-term debt issues. Although bond prices can fall when interest rates rise, these declines are typically far smaller than the potential losses on stocks. The American Century Ginnie Mae fund holds securities based on government-guaranteed packages of mortgages. Their chance of defaulting is lower than that of even blue-chip corporate bonds. The fund's current yield is 3.7 percent, and over the long term it has returned an annualized 6.5 percent.
To get a still higher pay out, you can invest in bonds from companies with less-than-perfect credit. The Vanguard High-Yield Corporate Bond fund holds issues rated below investment grade. Technically, bonds with ratings below BBB are considered "junk." But there's a world of difference between those that are just slightly subpar -- the issues that Vanguard High-Yield favors -- and truly distressed junk bonds that count as toxic waste. Vanguard High-Yield's risk is comparable to that of a conservative stock fund. The fund's current yield is 8 percent; its long-term rate of return is 6.4 percent. (The fund charges a 1 percent withdrawal penalty on assets held less than one year, but its rock-bottom expenses more than offset that.)
The average current yield for this group -- the two bond funds and the money fund -- is just about 4 percent; with an economic recovery, gains on the high-yield corporates might push that close to 6 percent. Obviously, if you want to withdraw 10.7 percent of your account each year, you need to earn a higher return than 6 percent. At that rate, you would run through your money in 15 years. With an 8 percent average return, you're good for almost 19 years. And with a 9 percent return, more than 22 years, which is where you want to be. So how do we get that extra return?
If you keep part of your money in income investments returning an average of 6 percent over the long term, you can reach the 9 percent level you need by finding other funds that achieve double-digit rates of return. Is that goal realistic? Well, over the long term, large-cap stocks have returned an average of 11 to 12 percent a year. (That counts both dividends and price gains.)
The most straightforward way to capture a slice of the market is the Vanguard 500 Index fund, which tries to match the performance of the S&P 500. Because the fund's manager makes almost no investment decisions and does no stock research, the fund's expenses are incredibly low -- about a quarter of the normal level. Since expenses come right out of your return, Vanguard's low cost gives it an advantage. The fund has earned an annualized 8.6 percent over the past 10 years.
The T. Rowe Price Equity Income fund holds more conservative stocks than the S&P 500 and focuses on shares that pay above-average dividends. The fund is actually less volatile than the overall market and its 9.9 percent annualized return over the past decade has bested the S&P 500, in part because the past few years have been so hard on the growth stocks that this fund avoids.
At the other end of the risk spectrum is Fidelity Mid-Cap Stock, which buys medium-size companies that have above-average growth potential. This fund has taken a big hit recently -- it's down more than 27 percent over the past year. But I think that just means midcap growth stocks are a bargain right now. If I'm right, the fund's long-term return could top 11 or 12 percent.
So far, we've used up six of your nine funds. For the remaining three, you want funds that offer protection against unpredictable market shocks. But they'll still need to earn an average long-term return of around 9 percent. So we're sticking with stocks but looking at sectors that often perform differently than the rest of the market.
The T. Rowe Price New Era fund was devised specifically to protect against unexpected inflation. It holds chiefly shares of natural resources companies, such as oil and mining, and its long-term historical rate of return is 8.5 percent. Vanguard Energy is more specifically focused on oil and gas stocks. Together with the New Era fund, it should protect you against an upsurge in oil prices. This fund is more volatile than some but has returned an impressive 10.5 percent a year on average.
The Fidelity Real Estate Investment fund is also an inflation hedge. The fund doesn't own real estate directly; it buys real estate investment trusts (REITs), investment companies that own equity stakes in properties and sometimes also invest in mortgages. In this tough bear market, the fund has gained 2 percent over the past 12 months, and it boasts a 10-year rate of return above 9 percent.
All together, these nine investments can come close to the 9 percent average annual return you need. At that rate, you would still be slowly eating through your capital -- unless a rebound in share prices greatly boosts the value of your portfolio. Nonetheless, you should be safe setting up an automatic withdrawal of $250 a month from each fund (excluding the money fund, which is a reserve for emergencies). That works out to the $2,000 a month you wanted.
You're probably anxious to get all your money invested as quickly as possible. But there's no rush. You might want to put the full $25,000 into each of your income choices and also make initial investments -- $10,000, say -- in each of the other funds. But I'd hold back the rest of the money until the Iraq conflict has been resolved.
After that, do as little as possible -- you probably won't need to make changes more often than once a quarter. Consider moving money out of a fund that has a big run. If the midcap stock fund shoots up from $25,000 to $35,000, for instance, you might shift $5,000 to a bond fund.
If any fund drops significantly, you should top it up by moving in some money from your most successful funds. That way, you'll be sure to have enough in each fund to sustain a $250 monthly withdrawal. And you'll always be selling high to buy low.
If the stock market enjoys a strong recovery, your retirement savings might grow to the point where it can provide the income you need practically forever. That's worth hoping for, anyway.
All the best, Michael.