According to the U.S. Census Bureau, nearly 8,000 Americans are turning 65 each day. This demographic shift will have a profound impact on the investment objectives of millions of Americans as they move into their retirement years. The investment industry for some time had been focused on building products that serve the accumulation needs of investors, and that helped many baby boomers build up sizable nest eggs over the years. But as baby boomers enter retirement, having investment solutions that focus on retirement distribution will be vital.

Portfolios for people saving for retirement should be structured differently from those already there. Retirement presents new challenges for investors as their primary investment objectives shift from accumulation of assets to distribution of their wealth. Retirees often find themselves having to manage the opposing forces of long-term growth and current income. They are concerned with preserving the wealth they have accumulated, while still providing the growth they need to sustain periodic withdrawals throughout their retirement.

The investment industry is responding to the call for solutions geared toward individuals drawing down their nest egg with a range of products such as annuities, income-oriented funds and fund-of-funds that seek to provide a regular payout. Rather than espouse the virtues of the various retirement income products out there, we will focus our attention on the fund-of-funds offerings and offer a practical account of how we design portfolios to meet this need.

The structure of the fund-of-funds offerings in the marketplace can take various forms, which may not be readily apparent at first, but can result in critical and fundamental differences. Some are designed to deliver consistent payouts and will dip into principal to achieve that, while others adjust the payout amount to avoid drawing down the principal. And some funds can be thought of as reverse target-date funds as they are designed to pay income to an investor over time until the fund is liquidated at its target end-year. These retirement income fund-of-funds may also vary in terms of their risk and return profiles, asset allocation as well as their underlying holdings.

Taking an Endowment Approach

At Morningstar Investment Services, we have created a suite of retirement income portfolios that follow an endowment-like approach that seek to deliver a target payout over time through their total return, while providing some protection against significant downturns in the markets. The target payout we aim to achieve serves as a guidepost for what investors can reasonably expect to take out of their account over time, but it is not guaranteed each year or automatically paid out at a set rate.

Many endowments invest across a variety of asset classes and tend to dedicate a significant portion of assets to areas that go beyond the traditional stock and bond mix. The retirement income portfolios we manage at Morningstar Investment Services take a page out of the endowment playbook as they are well diversified across various asset classes including domestic and international stocks; investment-grade fixed income; non-investment-grade fixed income; non-domestic fixed income; inflation-protected bonds; commodities; real estate; cash; and long-short mutual funds. The goal of incorporating this wide swath of asset classes is to create a more efficient portfolio that can potentially earn a higher rate of return for a given level of risk (or reduce risk for a certain level of return).

This endowment-like approach depends on drawing down the expected total return of a portfolio over time, rather than relying solely on an investment's yield or income return. While income can be an important source of total return for retirement income portfolios, a singular focus on yield could cause investors to potentially take on too much risk in the portfolio. It could also cause investors to overlook certain asset classes, such as inflation-protected bonds, that may not boast an eye- catching nominal yield but will provide important diversification benefits to help create more efficient portfolios.

The goal of this line of attack is to design a portfolio that gives investors a reasonable chance to withdraw a certain amount from their portfolios each year while having their money last through their expected time horizon in retirement. The practical implications are that as individuals progress through the various stages of retirement they need to reduce the risk that is inherent in their investment portfolio. Consequently, their allocation to less volatile investments, such as fixed income and cash, increases while exposure to more volatile asset classes, like equities, decreases.

Individuals just entering retirement still have a fairly long time horizon (likely more than 20 years depending on their life expectancy), and need a healthy amount of exposure to equities in order to protect against longevity risk. But they also don't want to be overly exposed to a volatile asset class. Individuals in the later stages of retirement need to pay more attention to protecting principal and can't afford the potential losses associated with taking on too much equity exposure.