A Portfolio to Keep Income Flowing

While pension funds are increasingly seen as relics from a bygone age, they can still teach investors a thing or two about managing money during retirement.


Pension funds and retirees have similar goals. A retiree is trying to maintain a certain standard of living, including the basics of having enough money to pay the bills for the rest of his or her life.

A pension fund, meanwhile, has to ensure it can make the payouts it owes to participants for the rest of their lives.

In both cases, the primary goal isn't to make as much money as possible or "beat the market." Instead, it's to create a portfolio of investments that will allow you to meet specific obligations -- no matter what happens in the markets.

This may seem like a distinction without a difference. But it requires a fundamentally different mindset and approach than investing to maximize returns.

It even has a name: liability-driven investing.

"You're not investing to maximize returns...you're maximizing the chance of being able to meet future income needs," says Christopher Jones, chief investment officer at Financial Engines, which provides asset-allocation services to 401(k) plans.

Compared with a growth-focused investment strategy, a liability-driven portfolio is more likely to have a heavier weighting toward safe bond investments that provide a predictable level of income and much less in stocks. And it's one where despite the high level of bond holdings, rising interest rates can actually be good news -- even though that hurts the day-to-day value of your bond portfolio.

The most straightforward form of liability-driven investing is a "bond ladder," a portfolio of U.S. Treasury bonds, which mature gradually over time and provide a guaranteed source of future cash.

Unfortunately, most individual investors don't have account balances big enough to make a bond ladder work. But it's possible to approximate the strategy with mutual funds, although it requires a more hands-on approach and discipline.

The challenge with mutual funds is that, unlike owning individual bonds, most funds don't mature and return a predictable amount of money at a specific date in the future. To approximate this key part of a bond ladder, an investor can buy a series of short, intermediate and long-term bond funds. However, it requires being diligent about gradually rolling the money down the maturity spectrum to shorter-term bond funds over the years.

Financial Engines, for example, will create an income-generating portfolio for a 65-year-old that is 80% bond funds and 20% stock funds. This is a much lower stock allocation than many target-date mutual funds, which put more than half of investors' money into stocks at that age.

"You could do a fund that is 60% stocks and 40% bonds and simply consume 4% or 5% of what there is in the portfolio every year," says Mr. Jones. "If the market does well, your income goes up. But if the market goes down, your income goes down."

He adds that "when you're in retirement, you want to minimize the chances that your income is going to go down. You want to use bonds to structure the income floor you can count on."

Bonds, of course, do have their risks, such as the possibility that an issuer will default on its payments.

In addition, bonds will lose value when interest rates rise. For someone holding individual bonds, this isn't an issue because that won't have an impact on the amount of income the bonds pay out.

In fact, this is one area that requires a different mindset: Higher rates can be a positive.

"If interest rates go up, the amount of money you need to meet your liabilities goes down," says Aaron Meder, head of U.S. pension solutions at Legal & General ( LGEN.LN ) Investment Management America, which specializes in liability-driven investing.

Here's why: If you need your portfolio to pay out $10,000 a year, at 4% interest rates you need $250,000 in bonds. But with 6% rates, you need much less, only $180,000 in bonds.

Also, the stock portfolio is there to help offset any losses that have to be taken in a bond-fund portfolio. The stock holdings, which hopefully grow in value over time, should be slowly shifted into bonds and potentially reinvested at higher yields.

"A situation where rates go up might be a great time to move money from a growth portfolio to [bonds] to lock in a reduction in retirement income-funding needs," says Mr. Meder.

This highlights a key point. "The thing that's different is you're no longer focused on the value of your portfolio, but what is the ability of those assets to meet your future liability," says Financial Engines' Mr. Jones.

One final piece of the puzzle: Investors still need to hedge against outliving their money. This is where an annuity, which guarantees income for life but locks up your money, can come in.

Financial Engines recommends taking about 15% of the portfolio and buying an annuity. But the firm suggests waiting until you're in your early to mid-70s to do so.