6 retirement building blocks

By Tim Middleton

Last week I noted which types of bonds are likely to perform best in the new bull market for bonds. But too many investors have no practical experience with bonds and don't know how best to corral these cash cows into an overall portfolio.

This is particularly unfortunate because the current market favors income investments. "We're not in a secular (long-term) bull market anymore," says Sheldon Jacobs, editor of the No-Load Fund Investor newsletter. "I see the next decade as being up and down. With securities that provide income, you're not as dependent on capital gains to get returns."

Inspired by Jacobs' excellent newsletter, which I've followed for years, I've adopted -- and adapted -- his ideas to outline a stocks-plus portfolio for at least the next decade, and perhaps the rest of your investment career.

In concept it's very simple: The shorter your time horizon, the more income securities you need to own. If you're under 45 and investing for retirement, you need only one bond fund, plus a money market, plus one equity fund with a strong income tilt, to provide the stability and risk-reduction that are this group's chief allure. It will account for only 20% of your total assets.

If you are retired you will boost this allocation as high as 65% and spread it among a half-dozen funds. For those in-between years, you'll choose a course halfway between these two.

Each portfolio building block has a specific purpose. Here are the purposes you need your bond or income elements to fill, and suggested funds to fill them. I'll use Jacobs's terminology and call these three steps Wealth Builder, Pre-Retirement and Retirement.

Cash

Every portfolio should have some of it, especially now, when short-term interest rates have been pushed higher than long rates and money market funds are beating other low-risk investments. But in any market, cash is valuable for bringing down total portfolio risk. Allocation: Wealth Builder 5%, Pre-Retirement 10% and Retirement 15% of total assets.

Two excellent candidates are Vanguard Money Market Reserves Prime Money Market Fund (VMMXX), if you have access, and SSgA Yield Plus (SSYPX) if you don't. In a 401(k) plan, the best choice could be a stable-value fund; compare yields with available money markets.

Basic bond fund

Jacobs' choice is also mine: Harbor Bond Institutional Fund (HABDX), which I described last week. This is an intermediate-term fund, meaning you get a higher yield than short-term funds, but your risks are lower than long-term portfolios.

This should account for 10% of total assets in all portfolios, except for this: In a taxable investment account, a municipal bond fund is better for high-bracket investors. T. Rowe Price Tax-Free Income (PRTAX) is good and also manages to sidestep the alternative minimum tax.

Wealth Builders are now done with bonds and can skip down a few paragraphs to equities.

International bonds

Templeton Global Bond Fund (TPINX) is an excellent choice, and has the flexibility to own U.S. bonds if foreign bourses are weak. I use T. Rowe Price International Bond Fund (RPIBX) in my own portfolio because it only invests in foreign securities, so I can manage the foreign-domestic mix myself.

For Pre-Retirees, I would suggest a 5% allocation to this fund; for Retirees, 10%.

Real estate investment trusts

These commercial-property securities are expensive now, which means vulnerable to a correction, but as a portfolio-builder their key attributes are as good as ever. They offer lush yields and they actually reduce portfolio risk because they react to different economic conditions than stocks or bonds.

In my model portfolio of exchange-traded funds I use iShares Cohen & Steers Realty Majors (ICF, news, msgs). Numerous mutual funds are also available, such as Vanguard REIT Index (VGSIX). For Pre-Retirees, 5%. You are done and can skip ahead to stock funds.

Retirees will want a 10% allocation to REIT funds, which leaves room for one more.

Multi-asset bond

No one can know how future fixed-income markets will behave, so Retirees need some flexibility in case offbeat bonds like below-investment-grade or emerging-market are timely. The choice here, for the final 5% of income assets, is a bond fund of funds.

Most major fund complexes offer them. Jacobs recommends T. Rowe Price Spectrum Income (RPSIX). According to Morningstar, the fund has more than 18% of assets in junk bonds and about 2.5% in emerging markets. (Price's Web site doesn't list the fund's holdings.)

Basic equity building block

You can wring income from stocks as well as bonds, and the kind of stocks that deliver high yields are also the most defensive, which is the type today's market favors. A good choice in this category is WisdomTree High-Yielding Equity Fund (DHS, news, msgs), an ETF that tracks an index currently yielding 3.96%.

Jacobs recommends TCW Dividend Focused (TGIGX), a large-cap fund that only had one losing year in the bear market and has delivered average total returns of more than 10% in each of the past five years.

I recommend a 10% allocation to this building block by both Pre-Retirees and Retirees. The former are now done. They have devoted 40% of their assets to bonds and stocks that are better at protecting wealth than increasing it, but by now they've got enough assets to worry about protecting them.

For the latter, I recommend one more income-oriented equity fund, in the amount of 5% of assets, simply to gain exposure to another corner of the market.

This is the riskier, but higher-yielding, world of small- and mid-cap stocks. Jacobs recommends a new mutual fund, Alpine Dynamic Dividend (ADVDX), which currently is yielding nearly 13%. As the fund lacks a substantial performance record, it's open to question whether it can continue to generate that yield.

My choice would be WisdomTree SmallCap Dividend Fund (DES, news, msgs), whose index is currently yielding 5.25%. This ETF is also new, but the manager has considerably less flexibility than that of the Alpine Fund, and consequently less room to make mistakes.

These are rules of thumb that don't necessarily fit your unique circumstances. Feel free to bend and stretch, but don't ignore the goal of reining in portfolio risk. Investments that provide tangible income are anti-Enrons.

A dollar you can put into your wallet might not be worth more than a dollar invested in a dream, but it's a real dollar and the other one isn't, at least yet. Get a grip on reality.

At the time of publication Timothy Middleton owned the following securities mentioned in this article: Harbor Bond, T. Rowe Price International Bond, T. Rowe Price Spectrum Income.