Reconsidering Your Retirement Income

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A narrow view of income in retirement leads to some bad decisions, says planner Mark Balasa. Plus, get tips on managing higher tax and interest rates.

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Reconsidering Your Retirement Income   Mark Balasa   morningstar   retirement financing   Retirement Income   retirement ira   retirement planning   roth ira   stocksReconsidering Your Retirement Income   

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Reconsidering Your Retirement Income Christine Benz: Hi. I'm Christine Benz for Morningstar.com. Today's retirees and pre-retirees face a challenging environment of very low yields and still depressed principal values following the bear market. Here to discuss some strategies that retirees and pre-retirees can use is Mark Balasa. Mark is a principal at the firm Balasa Dinverno & Foltz. Mark thanks so much for coming in today. Mark Balasa: My pleasure. Christine Benz: So, one question that I've certainly been hearing a lot from people, and I am sure you have as well is, this is a very low-yield environment. How should retirees think about managing their portfolios given that they are just really not able to generate much from what have traditionally been mainstays for retiree portfolio, so cash and bonds? Mark Balasa: You bet. Your question's a good one. If you think about the typical investor, especially if they have come close living in the depression or their parents did, and so forth, the view is that you can never touch your principal, and you can only live off of the income. Christine Benz: Right. Mark Balasa: And that shortsighted view of the income in retirement leads to some bad decisions, people tend to compromise their lifestyle, because they don't want to touch principal. Number two, they make the portfolio very interest rate-sensitive, because all they have in the portfolio typically—the majority of it, is in interest- bearing securities. Christine Benz: Right. Mark Balasa: So, what we encourage is for people to take a broader view and say look, number one, let's invest part of the portfolio so that it has a real return over inflation and taxes, right, which typically can be stocks, real estate, as well as bonds, and then CDs, and other fixed income instruments. But if you look at the portfolio in its totality and say, look I can get income from capital gains, interest and dividends, in years when it's bad, it's okay to go into principal, because in years when it's really good, you replenish some of that. So again, look at it in terms of total return and globally as opposed to just the income being generated off the portfolio. And it's especially going to be true going forward as the tax laws change, because current income, those rates are going to go up, because marginal rates are going to go up, and dividends and capital gains, those rates are also going to go up. So, understanding how your income is taxed is an additional consideration for someone in retirement. Christine Benz: So, of course, we don't know what tax rates are going to do or be, but I assume municipal bonds will be part of the prescription, you'd be thinking about in the face of higher rates? Mark Balasa: They are. For many taxpayers' municipal bonds and TIPS, inflation-protected bonds are going to be basic building blocks of their fixed income portfolios. But in light of rising income tax rates, it's going to be additionally important for investors to think about where their income is coming from. So we talk about tax diversification. You have your IRAs, which are everything that comes out, currently taxable at ordinary income tax rates. Christine Benz: The traditional IRA. Mark Balasa: Precisely. Thank you. Then, you have got your after tax savings, what people typically have in their portfolios, municipals and so forth, and now of course there is Roth IRAs, which essentially release through income without any income taxes. So, the idea would be, in retirement as rates go up, as they continue to go up, that's people's expectations, each year investor should be doing a small calculation for themselves, and look at, I want to get to the top of my next marginal bracket. And to keep myself there, I am going to either use Roth or capital gains to keep me from going into the next marginal bracket. And again, for families that have income of more than $250,000.00 married, filing jointly that's going to be additionally important because of the surtax coming. Christine Benz: So, are you thinking about a lot of partial conversions making sense for people to avoid bumping themselves into that higher income tax bracket with doing a Roth conversion all in one go? Mark Balasa: Yeah. I mean in 2010 here, we are definitely doing partial conversions for those who were doing. Still the minority of people end up being in the right mix of facts for that Roth conversion to happen. But definitely there tend to be more partial conversions than complete. But going forward, with what you've transitioned to Roth or what you've converted to Roth IRA gives you more flexibility in the future in terms of where you take your income to live off of so that you can minimize your tax liability in years in the future. Christine Benz: So, I'd like to talk about another challenge which is rising interest rates and what that means for retirees managing fixed income portfolios. On the one side, you'd be able to pickup higher yields as the years go by and rates go up. But in the near term, could that mean some dislocations, some losses in bonds and how do you manage with that risk? Mark Balasa: I mean, right now, I think, a lot of money managers and economists feel that for the next six months to a year, there is not a great deal of concern about rising interest rates. The economy is too fragile. Unemployment's too high, etcetera. But, you get beyond that intermediate term and what you just described is exactly the concern: that rising rates will erode a lot of the capital in your bond portfolio. So, I guess in the short term what I would say is, don't pull back your duration too quickly, on the bond portfolio. Christine Benz: It's a big opportunity cost to doing that right now too, right? Mark Balasa: Great point, that's exactly right. But as we get pass this immediate horizon, as you just described, to start pulling in the duration of your portfolio right now seems to be the right course of action, so that as those bonds mature, let's say you buy one-year bonds and you can reinvest them at higher rates as the rates go up. Christine Benz: So another area is in some of the corporate or junkier corporate bonds. That's another source of yield, but I'm wondering if you can talk about whether that is a viable component of retiree portfolios, and if you do have that junk bond sleeve, how much should it be? Mark Balasa: I think it is viable. Again, this goes back to how much risk the investor is comfortable with, because normally people take—they want to take risk on the stock side not the bond side, but if you're comfortable doing that there is valid reasons to do so. Number one, some of these different bond sleeves, as you talked, are bond asset classes, have lower correlations with, let's say, monies or Treasuries or corporate, and the yield, of course, is much more attractive, but that extra yield comes at obviously more risk. So, diversification is really important across the different types of high-yield instruments, whether its municipal high-yields, or corporate high-yields, or even international high-yields. Emerging-market debt and local currency, these are all examples of fixed-income instruments that have a higher yield than we do here, but again, with more uncertainty. Christine Benz: One last question, TIPS, as a percentage of a retiree's fixed income piece, I've seen some varying research and varying ideas on that topic, how do you think about it, how much should TIPS be of one's fixed-income stake? Mark Balasa: Sure. First of all, as you probably know or as I'm sure you know, TIPS are very tax inefficient. So, if all you have in your portfolio is taxable money, you wouldn't want to go too far with TIPS, because again tax inefficiency, I'll say maybe 5% or 8% of the portfolio. But if you have deferred assets IRA or Roth, and taxable, and you look at it in the aggregate, there I can see easily 15% maybe 20%. Some people are now—there's new instruments coming out for international TIPS, not just domestic. Again, when you look at international TIPS, though, think about, you're paying all of your bills, buying your groceries in U.S. dollars, not in foreign currency, so that's something to bear in mind. But a higher number, if you're looking at the portfolio, across both taxable and tax deferred. Christine Benz: Okay. Thanks, Mark. Some helpful insights, we appreciate you being here. Mark Balasa: My pleasure. Christine Benz: Thanks for watching. I am Christine Benz for Morningstar.com.

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