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It's a privilege to manage my mom's portfolio as a registered investment advisor, and it affords me the opportunity to be painfully candid about the money management process. My goal is to use this portfolio illustration to help investors like my mom, so I'll try to avoid 25-cent words and phrases. But since I tend to be an egghead, I'm sure a few will slip through.

  • The recipe combines 40% dividend stocks, 40% corporate bonds, 10% cash, and 10% in a fixed annuity. This mix now yields 3.7%.
  • The core portfolio has just two ETFs: the WisdomTree Equity Income Fund (DHS), and the iShares iBoxx $ Investment Grade Corporate Bond Fund (LQD).
  • The asset mix is simple, liquid, and cost-effective, and is suitable for conservative retirement investors.
  • My investment outlook is conventional: slow growth, low returns, high volatility, and a preference for corporate risk over sovereign risk.
  • The portfolio uses annuities sparingly to boost income without sacrificing liquidity.
  • All told, this humble approach may be well-suited for a world of low returns and falling fees.

Readers should note that this is an illustration, and not a recommendation. Since I don't know your situation, I can't offer you advice. And I don't want to get sued, thank you very much.

Client Profile and Suitability

My mom, Jean C. Martorana, is a widow in her early 80s. She has good overall health, and a life expectancy of 10-15 years. (One online calculator predicted that my mom will live to be 103, so I'll have to stock up on birthday candles.) Her income from a pension and social security cover her living expenses, and she also has some real estate. The focus of this article, however, will be on the assets in her taxable account. (Fortunately, her tax rate is low.)

The goal of the portfolio is to generate income, and it needs to hedge against inflation. My mom has a conservative risk tolerance, and she is concerned about outliving her portfolio, and her withdrawals vary each year due to unusual expenses. So even though the main goal is income, the portfolio needs liquidity.

Finally, I'll note that my mom may be a sophisticated person, but she is not a sophisticated investor. My mom earned a master's degree in Clinical Psychology in 1952 (go mom!), and she had a long and varied professional career. But like many women of her generation, she left the finances to my dad, who did just fine. My point is this: I want a solution for my mom that is as simple as possible, and without exotic hedges or risky asset classes. She wants income from this portfolio, not entertainment.

The 4% Rule for Withdrawals

Like most retirees, my mom wants to maximize her income without outliving her money. Many investors are familiar with the "4% rule" pioneered by William Bengen (pdf) in 1994. His studies show that a 50/50 mix of stocks and bonds has historically allowed investors to withdraw 4% of their money each year without depleting their retirement portfolio.

The 4% rule is based on strong statistical evidence, though it isn't perfect (a good critique can be found in this article from Vanguard). Nevertheless, the 50/50 mix of assets is a good place to start, and history suggests that my mom can spend the income from this portfolio without depleting it. The portfolio now has a yield of 3.7%, which is certainly better than what she was getting at the bank.

Following Conventional Wisdom About the Economy

My mom's portfolio is not on the cutting edge, and neither are my economic assumptions. Like most investors, I expect sluggish global growth for the foreseeable future, since nearly every developed nation is addicted to debt. The Fed plans to keep pumping morphine into the system, keeping interest rates near zero, so retirees like my mom earn practically nothing. Given our mammoth federal and local deficits, I do not find Treasurys or municipals attractive. I believe that these bonds will earn less than 2% over the next five years, while inflation chugs along at a pace of 3% to 4%. Not good.

Meanwhile, I think that stocks will return about 7% per year, with high volatility. I realize that a slow global growth doesn't seem great for stocks, but corporate profits have been disconnected with the economy for quite some time (as I pointed out in 2009 in The Deflation of the American Dream). So even as Europe wilts and America muddles through, global multinationals can rapidly redeploy assets to emerging markets. Hence, the outlook for corporate profits and U.S. equities is not too bad.

In this environment I believe stocks will offer a modest buffer against inflation, since corporations can usually pass on rising costs to customers. (The first half of 2012 is an exception, since margins are getting squeezed.) I also note that U.S. corporate balance sheets are strong, with lots of cash and strong free cash flow. Overall, I continue to favor corporate risk over sovereign risk (pardon the jargon - that means government bonds, which are not in the portfolio).

Statistics on a 50/50 Portfolio in DHS and LQD

This portfolio holds a 40% position in the WisdomTree Equity Income Fund , and a 40% position in the iShares iBoxx $ Investment Grade Corporate Bond Fund . As noted above, a 50/50 mix of stocks and bonds provides a sound allocation for portfolios in retirement, and 40/40 mix of dividends and corporate bonds boost the portfolio yield to 3.7%. (This includes 10% in cash and 10% in annuities, which did not materially affect the overall yield). This compares with a yield of just 2.2% for a 50/50 portfolio invested in the S&P 500 (SPY) and the Barclays Aggregate Bond Index (AGG). So the shift into dividends and corporates boosts the yield by 1.5%.

How does mom's portfolio stack up against a market portfolio? I did some rough backtesting to find out, though it is not an apples-to-apples comparison. That's because mom's portfolio benefited from quarterly rebalancing. In addition, I excluded the cash and annuity portions, and just tested the stock and bond part of the portfolio. Cash and annuities make a portfolio more stable, so mom's actual results should be more stable than the historical sample.

As it turns out, mom's portfolio did not beat the market. When I tested a 50/50 mix of DHS/LQD against a 50/50 mix of AGG/SPY, the blend of DHS/LQD returned 4.8% over the last five years with a standard deviation of 12.6%. Meanwhile, a 50/50 blend of SPY and AGG has generated a return of 5.1% over the same period, with a standard deviation of 9.2%. This is better than the DHS/LQD portfolio, but I don't expect the next five years to resemble the last five years. I think the DHS/LQD portfolio is better positioned for a slow- growth environment, and the higher yield is well suited for my mom's goals. In other words, yesterday's loser could be today's winner.

Closeup on DHS: High Valuation and Low Financial Exposure

I like dividend stocks in the current environment, since high-dividend payers tend to be in defensive industries, and dividends impose corporate discipline. Last August I described the bull case for the WisdomTree Equity Income Fund. [Click here (pdf) for the factsheet on DHS.]

I still like DHS, which has an expense ratio of 0.38% and now yields 3.3%, compared to just 2.1% for the S&P 500. Granted, DHS is concentrated, and the top five holdings account for 26% of the total: AT&T (T), General Electric (GE), Pfizer, Johnson & Johnson (JNJ) and Procter & Gamble (PG). DHS also has a higher valuation than the market. This premium for DHS suggests that investors prefer defensive, high-dividend stocks. The P/E for DHS is 14.8 (vs. 13.7 for the S&P 500), and DHS has below-market measures of growth in sales, cash flow, and book value. Thus, investors are paying a premium multiple for slow growth.

Why? Perhaps it's because DHS is underweight banks. I noted this last August, and today DHS has less than 2% in bank stocks (vs. about 12% for the S&P 500). Bottom line: DHS offers a high yield and no banks.

Closeup on LQD: Overweight Banks

I also like corporate bonds, and the iShares iBoxx $ Investment Grade Corporate Bond Fund [click here (pdf) for a fact sheet on LQD.] This fund now offers a yield of 4.0% vs. a mere 2.1% for the bond market, as measured by the Barclays Capital U.S. Aggregate Index . In other words, corporate bonds offer a yield that is almost double that of the overall U.S. bond market.

LQD has an expense ratio of 0.15%, and the fund owns a lot of long-term bonds. The fund's effective duration is 7.5 years, so the fund would lose money if inflation surges and interest rates rise. What about credit quality? Is this fund OK for my mom? Well, 80% of the bonds are investment grade, and two-thirds are rated A- or better. So far, so good.

The biggest challenge for investors is that LQD holds a lot of bank debt: 26.7% of its holdings were in the banking sector as of 9/30/11. Tuesday's article on SeekingAlpha stated that 34.7% was in banks, and I calculated 36.0% based on holdings as of 12/30/11.

Regardless of the exact level, LQD's heavy weighting in financial bonds is not all in low-rated bank debt. It includes insurance companies, and strong credits: investment-grade positions in firms such as J.P. Morgan (JPM) and Wells Fargo (WFC). But the banking exposure in LQD may be the biggest single risk in this portfolio, and requires ongoing monitoring. This is especially true for the long-dated bonds in Morgan Stanley (MS) and Bank of America (BAC), and LQD includes bonds from these issuers and others that have a yield-to-maturity of 7% or more. (Note to mom: 7% is a high yield these days, and indicates trouble.)

To put the bank bonds in perspective, I am more willing to accept the risks of owning bank debt, rather than bank equity. If a bank fails, you want to be a bond holder, not a shareholder. And since mom's overall portfolio is underweight bank stocks, it is easier to accept the overweight in bank bonds.

Simplified Risk Controls

Speaking of risk, an investor might ask: Where are the hedges in this portfolio? Why the focus on the U.S. - is this a case of "home-country bias?" Well, I believe that my mom is better off with assets that she can understand, and with a concentration in the country where she lives and spends money.

Look out - here comes the hate mail: "You're not protecting your mom from inflation, depression, and economic apocalypse."

Point taken. But I wanted this portfolio to be simple, so I will manage risks by monitoring the portfolio and selling when necessary. This is not a "permanent portfolio" by any means; it's simply one idea for conservative retirement income. Since the portfolio is well diversified, I believe I'll have enough time to respond to changing circumstances, and avoid the worst of the downside.

Now that I've talked about the stocks and bonds, it's time to consider annutiies.

Some Exposure to Annuities Is Good...

About 10% of my mom's investable portfolio is in an immediate fixed annuity yielding 8%. This offers guaranteed income for life, which is ideal for a retirement portfolio.

Annuities are often overlooked because the products are complex and the fees can be high. Even sophisticated institutional investors can be snobs when it comes to annuities. But a modest allocation almost always improves a portfolio by generating high income. This boost comes from mortality credits. What's that? As the CFA Research Institute so gently puts it, "this represents the capital and interest lost by annuity holders who die, allowing surviving annuity holders to earn a superior return" (page 55, here). Thus, mortality credits are part of the basic economics of annuities, and make annuities attractive for people like my mom.

I'll note that the benefit of annuities is not captured in Modern Portfolio Theory, which doesn't deal with longevity risk. For suggestions about how annuities can be effectively allocated to retirement portfolios, I suggest pages 275-290 of Paul Kaplan's "Frontiers of Modern Asset Allocation."

...But Too Much Hurts Liquidity

The biggest single drawback to annuities, especially fixed immediate annuities, is that they reduce the liquidity of the portfolio. An annuity can also reduce the potential size of a retiree's estate, and the policy may have significant surrender charges. Consequently, I always recommend consulting a trusted professional before buying. (The key word here is "trust," as I note in the cautionary tale below.)

We avoided these problems in mom's portfolio by allocating just 10% of her portfolio to annuities, and by making provisions for her estate elsewhere. Finally, she bought the annuity directly from a religious charity, so the profits benefit a good cause.

The remaining 10% of this portfolio is in cash, which provides an extra buffer for unforeseen expenses. This completes my review of mom's portfolio, and I now offer…

A Cautionary Tale About Advisors

When I build portfolios for any client, I often think of my family's first experience with financial advisors. Back in 1973, my grandmother owned lots of stock in Exxon-Mobil (XOM) that she had inherited. (My grandfather had worked at a steel company that was later bought out by Exxon.) One day, an advisor contacted my grandmother and warned her of impending doom of owning Exxon. He convinced her to sell, and he got a big commission on the trade. We never heard from him again.

At the end of 1973, my grandmother got a big tax bill and an even bigger surprise: OPEC began an oil embargo. The price of Exxon began to soar, and a $1,000 investment in 1974 would be worth over $28,000 today (according to Exxon's calculator here). As you might have guessed, my family lost faith in financial advisors. And I learned how incentives often drive financial advice.

Today, ETFs and index funds are making it easier than ever to construct simple, diversified portfolios. I believe that fee-based advisors are much more likely to use low-cost products, and are more likely to offer simple solutions. As you may have guessed, I'm a fee-based advisor and a fiduciary. Incentives matter in portfolio construction. They always have and always will.

A fiduciary approach is no guarantee of success, of course, nor am I saying that you should never pay for premium products and services. Of course you should. But you should reject complexity when it's done for the wrong reasons - to dazzle clients, to sound smart, or to boost fees.

Sometimes simple is best.

In loving of memory of my father, John A. Martorana, without whom there would be no portfolio for mom (and no portfolio manager, either).

Source: My Mom's Portfolio: A Simple Recipe For Retirement Income

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