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A Conservative Asset Allocation For Income-Focused Investors

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retirement

Despite the headlines that make it seem as if every baby boomer is going to struggle to pay the bills in retirement, there are some people who have done an excellent job saving for their post-full-employment years.  For those people, the challenge will be less about worrying whether they can afford to pay the bills and more about educating themselves so that they properly manage their investment portfolios.  Over the next few weeks, I will write a series of articles geared toward investors who have built moderate-to-large nest eggs and are looking for general ideas about how to allocate their investments.

To see a list of high yielding CDs go here.

From a financial standpoint, one of the most important things you can do in retirement is manage your cash flows appropriately.  In general, the process of managing cash flows starts with the following calculations:

  1. Calculate the annual amount of money you need to live.

  2. Subtract Social Security, pensions, part-time jobs, rental income, and other non-financial-markets-related income from the amount of money you need to live.

  3. The remaining amount is the amount that needs to be funded by income generated from your investments.

At this point, asset allocation comes into play.  We all have different risk tolerances.  But I am willing to bet a majority of investors will sleep better at night moving down the risk curve as they enter their retirement years.  In this article, I would like to offer one generally more conservative asset-allocation model.  Naturally, there are countless variations investors could create, and your investment objectives, risk tolerance, and time horizon will help shape your allocation.  Next week, I will explore two additional asset allocations that take on more risk and generate more income than the one below.

 

Asset Allocation

Today isn’t exactly an ideal investing environment for putting together an income-producing portfolio.  Bond yields are still at historically low levels and stocks are generally not cheap.  Nevertheless, thousands of people are reaching the traditional retirement age each day.  Those people will have to play the hands they are dealt.  With that in mind, what follows is an example of an asset-allocation model conservative investors with $1 million in retirement savings could consider.

 

Generally More Conservative Asset-Allocation Model

Investment Grade Bonds and CDs – 50% of portfolio ($500,000)

  • 50% of the portfolio ($500,000) laddered into individual investment grade corporate bonds and certificates of deposit with less than 10 years to maturity.

  • Position sizes would range from $10,000 to $20,000, depending on your view of the company.  This would allow for adequate diversification.

  • Given that I think the federal funds rate will not be raised for at least two more years and possibly longer, I think the bond-and-CD ladder should begin at three years.

  • As a result of the challenging yield environment, and in an effort to generate more income for the portfolio, I would structure the ladder something like this:

    Amount

    Year 3

    $50,000

    Year 4

    $50,000

    Year 5

    $50,000

    Year 6

    $50,000

    Year 7

    $50,000

    Year 8

    $75,000

    Year 9

    $75,000

    Year 10

    $100,000

    Total

    $500,000

  • Based on the individual investment grade bonds and CDs trading in the secondary market at the time this article was written, an investor laddering in the manner described above could conservatively expect to generate the following yields and cash each year:

Amount

Minimum Average Yield

Cash Generated

Year 3

$50,000

1.25%

$625.00

Year 4

$50,000

1.50%

$750.00

Year 5

$50,000

2.00%

$1,000.00

Year 6

$50,000

2.25%

$1,125.00

Year 7

$50,000

2.70%

$1,350.00

Year 8

$75,000

3.50%

$2,625.00

Year 9

$75,000

3.75%

$2,812.50

Year 10

$100,000

4.25%

$4,250.00

Total

$500,000

2.9075%

$14,537.50

 

  • You likely won’t generate “real” yields from all the rungs.  But this is a conservative allocation from the standpoint of nominal principal preservation.  Additionally, the purpose of laddering is to ensure that if inflation and yields do tick up, you have funds maturing in the near future that can be rolled into higher-yielding securities.

 

Preferred Stocks and Exchange-Traded Debt – 10% of portfolio ($100,000)

  •  10% of the portfolio ($100,000) invested in individual preferred stocks and/or exchange-traded debt.

  • Position sizes would range from $10,000 to $15,000, depending on your view of the company.  It will not be difficult to obtain an average yield of no less than 6% on this allocation ($6,000 of annual income).

 

Non-Investment Grade Bonds – 10% of portfolio ($100,000)

  • 10% of the portfolio ($100,000) allocated to non-investment grade bonds.

  • This money should generally be focused on maturities in the three-to-eight-year range.  Whether this is accomplished by purchasing 10 bonds from 10 different issuers or by using non-investment grade bond ETFs is a judgment call.  Even in today’s environment, I would expect this allocation to generate no less than $5,000 per year.

Total Cash Flow From Bonds, CDs, Preferred Stocks, and Exchange-Traded Debt:

  • $14,537.50 + $6,000 + $5,000 = $25,537.50

*** I purposefully left municipal bonds out of the equation.  Munis are best suited for investors with higher incomes.  If your taxable income is such that munis make sense for you, they should be built into the investment-grade portion of the total bond allocation.

 

Stocks – 18% of portfolio ($180,000)

  • U.S. indices – 9% ($90,000) – yielding no less than 1.90%.  One index fund is sufficient.

  • World, ex-U.S. indices – 4.5% ($45,000) – yielding no less than 2.5%.  One or two index funds are sufficient, depending on the fund chosen and the amount of exposure you want to certain parts of the world.  For example, the Vanguard FTSE All-World ex-US ETF (VEU) has less than 20% exposure to emerging markets.  Investors wanting to increase emerging-markets exposure, while also maintaining exposure to other parts of the world, could own both VEU and the Vanguard FTSE Emerging Markets ETF (VWO).

  • Dividend-paying multinationals (individual stocks) – 4.5% ($45,000) – yielding no less than an average of 2.75%.  A $45,000 allocation to individual dividend-paying stocks should be broken into no less than five stocks.

Total Cash Flow From Stocks (excluding the potential for dividend growth): $4,072.50

Additionally, assuming a compound annual dividend-growth rate of 5% for the entire allocation to stocks, the $4,072.50 of annual dividends would grow to $6,317.78 of annual dividends by year 10.

Amount

Year 1

$4,072.50

Year 2

$4,276.13

Year 3

$4,489.93

Year 4

$4,714.43

Year 5

$4,950.15

Year 6

$5,197.66

Year 7

$5,457.54

Year 8

$5,730.42

Year 9

$6,016.94

Year 10

$6,317.78

 

Stores of Value – 5% of portfolio ($50,000)

  • The world is currently in the midst of a grand monetary experiment, the likes of which has never been seen on a global scale.  Nobody knows what the ultimate outcome will be.  I think it makes sense to at least have a minimal allocation to the store of value that has outlived fiat currency after fiat currency.  Especially for investors with heavy exposure to fixed-income securities, owning a store of value that has stood the test of time is important.  I favor gold.  Others may prefer a different store of value.

 

Cash – 7% of portfolio ($70,000)

  • “High-Yielding” checking/savings account(s) yielding at least 10 basis points – $70 of interest.

  • The yield from a checking/savings account can vary.  Should short-term interest rates head higher, it is likely the cash kept in a bank account will generate more income.

 

Total Annual Cash From Generally More Conservative Portfolio

  • $25,537.50 + $4,072.50 + $70 = $29,680.00

  • $29,680.00 is the minimum one would expect from this type of allocation at today’s yields.

  • The yield on the total portfolio is 2.968%.

  • The yield on the non-cash, non-store of value portion of the portfolio is 3.36%.

 

A generally more conservative portfolio yielding 2.968% in today’s historically low interest-rate environment is not bad.  This is especially true considering the potential for dividend growth from the equities allocation, and the potential for reinvesting the laddered bond allocation at higher rates as bonds mature.  As I mentioned earlier in the article, next week, I will explore asset allocations that take on more risk and generate more income than the one above.

 

Conclusion

Once you identify the general allocation you want to have for the first day of retirement, you will need to begin choosing the specific securities that will comprise the portfolio.  I think it is best to give yourself a couple of years to identify and purchase those securities.  By beginning the transition from a non-retirement allocation into a retirement allocation a few years before you will depend on the portfolio, you will likely allow sufficient time to strategically enter positions at more favorable prices.  The challenge, of course, will be to identify securities that are trading at attractive levels.  To help you in that endeavor, consider Income Investing Insider.  It is a monthly newsletter I write, designed to help people generate income-focused investment ideas and keep abreast of important macro- and investing-related considerations.

*The asset-allocation model described in this article is impersonal.  The asset-allocation model described in this article should not be viewed as investment advice.  Only you can decide the allocations and securities that are appropriate for your portfolio.

More from The Financial Lexicon:

The 5 Fundamentals of Building a Retirement Portfolio

Options Strategies Every Investor Should Know

 

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All trading carries risk. Views expressed are those of the writers only. Past performance is no guarantee of future results. The opinions expressed in this Site do not constitute investment advice and independent financial advice should be sought where appropriate. This website is free for you to use but we may receive commission from the companies we feature on this site.

3 Comments

    • Regarding tax-advantaged accounts, keep the following in mind: (1) if you have to choose between the two, there is a tax advantage to holding securities paying interest rather than qualified dividends in tax-advantaged accounts. (2) if you eventually plan to realize capital gains, rather than hold your stocks “forever,” it may be advantageous to hold them in a tax-advantaged account and realize the gains after your full-time employment is ended. (3) You will have a difficult time allocating money to individual securities in most 401(k)s. With that in mind, you would have to wait until retirement to actually build the allocation noted above. Regards, TFL

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