Is an Annuity Right for You?

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1 March 2009 SM Volume 5 Number 3 Is an Annuity Right for You? I ll admit it; I m biased against annuities. Once you venture outside the realm of plain-vanilla immediate fixed annuities, where you hand over a lump sum of cash in exchange for a regular income stream, the annuity landscape is full of costly and confusing options. As the saying goes, annuities are typically sold, not bought, and I think there are better, more cost-effective ways to obtain tax-deferred growth. Yet I know that many of you are seeking some measure of protection as well as income in the wake of the ongoing bear market, and annuities often promise to deliver both. With new flavors of annuities hitting the market nearly every day, I wanted to check up on the current landscape for annuities. Which, if any, of these newfangled (or oldfangled) products are worth investing in, and which should you avoid? Choice Overload All annuities are contracts with an insurance company, whereby you pay in with the understanding that the company will send you a stream of income. You can choose to receive the income within the first 13 months of your contract (an immediate annuity) or at some point in the future (a deferred annuity). With a fixed annuity, you earn a predetermined rate of interest on your investment. If you invest in a variable annuity, you ll have control over how your assets are invested, and the size of your account will vary based on how those investments perform. Equity-indexed annuities, which have grown in popularity in recent years, promise to be kind of a hybrid between a variable and fixed annuity. They allow you to earn returns that are higher than you d be able to get with a fixed annuity, but provide a measure of downside protection not available with a variable annuity. Pretty simple, no? Well, not really. Beyond those basic types, the annuity landscape encompasses a bewildering array of products and, within each product type, a multitude of bells and whistles (and attendant fees) that one could choose. Fixed Immediate Annuity The most straightforward type of immediate annuity is a single premium immediate annuity, or SPIA. With a SPIA, you give the insurance company a slice of your assets, and in exchange you receive an income payment, usually monthly, for the rest of your life, much as you would with a pension. For example, a 65-year-old man with $100,000 to put into an annuity right now could receive a monthly income payment of roughly $700. With the most basic type of SPIA, you receive income over the course of your own lifetime, and your income payments cease when you die. That can be a good deal if you re in good health and have longevity in your family. For example, if the aforementioned man were to pass away at 105 years of age, he d receive that $700 per month right up until the end, even though his original $100,000 had long since been depleted. On the flip side, if our retiree were to die early in the life of his contract, the insurance company would go home the winner, pocketing much more than it ever paid out. Continued on Next Page Christine Benz, Director of Personal Finance Investment Insights 6 Where to Go for Income Portfolio Makeover 10 Playing It Safe (but Not Too Safe) for Retirement

2 2 Annuity Dos and Don ts Do: 3 Ask your financial advisor why he or she thinks an annuity is preferable to investing in other tax-sheltered vehicles. 3 Ask for a specific breakdown of the costs associated with the annuity investment. 3 Consider adding inflation protection if you opt for a fixed annuity. 3 Research the ratings of the insurance companies offering annuities. Don t: 3 Turn to a variable annuity unless you ve fully funded other tax-sheltered options such as an IRA or 401(k). 3 Shelter annuities inside an IRA or 401(k), because you re doubling up on tax benefits. That last scenario is an unpleasant one to contemplate, so insurance companies offer many features to help you avoid it. Not surprisingly, each protective feature you layer on reduces the size of your payout. So, for example, many individuals choose to have their fixed immediate annuity provide income not just during their own lifetime but also that of their spouse. Say, for example, the aforementioned 65-year-old male buys a joint lives annuity to provide income for as long as both he and his wife are alive. In that case, his $100,000 translates into a $590 monthly payment because the insurance company is reckoning (based on actuarial tables) that the wife will outlive her husband by at least a few years. In addition to buying an annuity to cover your life and your spouse s, you can also add on features that provide benefits to your children or other beneficiaries after you ve died. You can also buy a fixed immediate annuity with inflation protection, so that your payment steps up along with prices. something like a savings vehicle, where you can sock away money for retirement and earn a predetermined rate of interest. In fact, a fixed deferred annuity is somewhat (but not entirely) like putting a CD inside of an IRA. Like CDs, these vehicles guarantee you a fixed albeit relatively low interest rate. They also offer some of the same tax treatment as a traditional nondeductible IRA receives: Your contributions are nondeductible, but your investment grows on a tax-deferred basis. You will also owe a penalty if you take your assets out before you re 59 1/2, as is the case with a traditional IRA. The key differences versus an IRA are that the IRS doesn t impose any limits on how much you can stash in one, and you don t have to take assets out by age 70 1/2. Some fixed deferred annuities also include a death benefit, payable to your heirs, if you die before you begin taking income from your annuity. PROS» Helps provide protection against outliving your assets. Can be a cost-effective way to obtain a predictable income stream. PROS» Allows assets to grow at a predetermined rate. Offers many tax benefits of a traditional nondeductible IRA but has no income or contribution limits. CONS» Annuity rates are loosely correlated with interest rates. Because interest rates are currently low, annuity payouts are also pretty low right now (higher than what you d earn on a CD, but not a lot higher) and go lower as you add more features. Once you ve bought one of these contracts, it can be difficult to get out of it. BOTTOM LINE» I like plain-vanilla fixed immediate annuities for a slice of an investor s portfolio to help hedge against longevity risk. However, remember that the amount you stash in a fixed annuity won t be able to grow, so I d limit a fixed immediate annuity to roughly 20% or less of a portfolio. Also, be sure to check up on the financial health of the insurer. Fixed Deferred Annuity Unlike a fixed immediate annuity, you don t begin taking payments from a fixed deferred annuity right away. Instead, the fixed deferred annuity functions CONS» Although fixed deferred annuities sometimes entice with high teaser rates that are attractive compared with CDs or other short-term vehicles, those rates often reset to lower levels. True, fixed deferred annuities typically offer a guaranteed minimum interest rate, but that can be quite low after the teaser period ends. Moreover, fixed deferred annuities, unlike CDs, don t offer FDIC protection, and you can t tap them for short-term income needs before you re age 59 1/2. You also may owe a surrender charge if you need access to your money early on in the life of your contract. BOTTOM LINE» Fixed deferred annuities offer the peace of mind of a fixed rate and have some attractive tax characteristics, but they re not a top choice for investors who need to grow their principal. They also often impose surrender fees on investors who need to tap their money within the first few years of the contract. (Annuities typically offer a free look provision, however, that lets you get all your money

3 Morningstar PracticalFinance March Exclusive Offer! $30 Off Premium Service! For a limited time, Morningstar PracticalFinance subscribers can receive $30 off a subscription to s Premium service. The service offers access to all of the tools mentioned in this article, including Asset Allocator, as well as unlimited access to Morningstar s stock, fund, and ETF Analyst Reports. l Visit: back if you cancel the contract within a set number of days.) Variable Annuity Unlike fixed annuities, variable insurance products give you a level of control over your investment selections including the opportunity to invest in stocks. The account value of a variable annuity fluctuates with the direction of your investments. The ability to own stocks makes a variable annuity a better choice when asset growth is a priority, though it can be a mixed blessing when stocks are dropping, as they have been recently. Variable annuities also come with insurance components, including a death benefit payable to your heirs if you die before you annuitize. VA investors can also layer on other so-called living benefits, such as guaranteed minimum withdrawal benefit riders, which allow VA owners to withdraw a fixed percentage of the benefit base each year until death. As with the deferred fixed annuity I discussed above, a deferred variable annuity (by far the most common type of VA) functions something like an IRA, although you must choose your investments from a set menu of mutual funds, called subaccounts. Variable annuities receive generally the same tax treatment as deferred fixed annuities: Your contributions aren t tax deductible, but your investments can compound on a tax-deferred basis. You ll also owe ordinary income taxes upon withdrawal. (More on this in a moment.) The tax benefits can make VAs an option if your company doesn t offer a retirement plan and you re maxing out your IRA options. The biggest knock against VAs justified, in my view is their several layers of costs. The management costs associated with running the investments are, in some cases, even lower than mutual fund management fees. But because annuities offer a death benefit usually guaranteeing to provide your heirs with an amount equal to your initial investment if you die before you annuitize they charge an additional expense called a mortality and expense (M&E) charge. That element of protection can provide peace of mind, but in reality, few VA owners end up using their death benefits, and the associated costs can be a drag on your long-term returns. You ll also pay additional fees for any features you layer on, such as guaranteed minimum withdrawal benefits. When all of those expenses are factored in, you can easily pay much more than you would for a comparable mutual fund coupled with separate insurance coverage. Finally, some VA policies have onerous surrender charges if you need your cash early in the life of your policy. (VAs also typically have a free look provision, however.) Secondarily, VAs don t always offer best-of-breed mutual funds. Most VA policies include solid options from the big firms, including investments by T. Rowe Price, Fidelity, and Franklin, but they tend to be heavy on the house brand of funds. Also, you d be hardpressed to find subaccounts run by top investment boutiques like Longleaf, Artisan, or Third Avenue. That shouldn t rule them out, but it does underscore that you re choosing from a set menu. Finally, while VAs allow for tax-deferred growth of capital, the taxation upon withdrawals is unattractive. Variable-annuity holders will pay ordinary income tax on their investment gains upon withdrawal, whereas investors who have held stock mutual funds in a taxable account for at least a year will pay the much lower capital gains rate of 15%. PROS» For those with long time horizons, the ability to enjoy equity-market participation is valuable. Variable annuities also offer tax-sheltered growth and unlimited contributions for those who have maxed out their tax-deferred options. Those who layer on guaranteed withdrawal and income benefits also buy themselves income and a measure of principal protection. CONS» Variable annuities often have several layers of costs, including M&E charges, underlying fund costs, administrative expenses, and fees for option benefits. Surrender charges may also apply if you need to withdraw assets early in the life of your contract, usually within the first five years. Tax treatment upon distribution is also unattractive

4 4 relative to stocks and stock mutual funds held in taxable accounts for at least a year. BOTTOM LINE» If you re maxing out your contributions to all of your tax-advantaged options including IRA and company retirement plans variable annuities provide another way to defer taxes. However, it s worth noting that many stock funds have big tax-loss carryforwards on their books currently, making VAs tax benefits less valuable at this juncture; it s possible to construct a mutual fund portfolio that won t pay out any capital gains for several years to come. Moreover, gains in variable annuities are taxed at your ordinary income tax rate, not the lower capital gains rate. That further reduces the chances that a VA will be more tax-efficient than a mutual fund. Those tax issues, along with VAs layers of fees, make them hard to recommend, particularly at this juncture. If you re determined to buy a VA, stick with the lower-cost options; Vanguard and Schwab both field decent VA products. Equity-Indexed Annuity These vehicles, often pitched as a happy medium between fixed and variable annuities, have exploded in popularity over the past several years. Although there are many different variations, the basic idea is the same: Equity-indexed annuities typically promise some guaranteed rate of return, much like a fixed annuity, but they also offer participation in the equity market s returns. Under a typical scenario, an equity-indexed annuity will offer a minimum return that amounts to 90% of the premium paid at a 3% interest rate. In an up market, it will also offer a percentage of the return of a stock market index, usually the S&P 500. Some equity-indexed annuities cap the equity gains you re eligible to receive. As with the other annuities, earnings in equityindexed annuities grow on a tax-deferred basis, and holders pay income tax on their distributions. Equity-indexed annuities also typically include a death benefit. When stocks were going up, critics bemoaned that owners of equity-indexed annuities would receive only a fraction of the stock market s gains. More recently, however, owners of these annuities may be feeling pretty smart because they ve been able to limit their stock market-related losses. Still, there are a couple of persistent issues with equity-indexed annuities. The first is that they re complicated. Insurers use different methods of calculating the index return that holders pocket, and you need to read the fine print to determine how your own return will be calculated. Moreover, equityindexed annuities don t typically include reinvested dividends when calculating index returns, yet dividends have historically accounted for nearly 40% of the market s total return. Finally, equity-indexed annuities often carry steep surrender charges, though some insurers waive them for medical reasons or other emergency expenses. PROS» In a declining market like the current one, equity-indexed annuities give holders some safeguards if the stock market performs poorly. CONS» In a strong up market, investors in these vehicles will see their gains muted. These vehicles are also complicated and can carry significant surrender charges, as well as a tax penalty if you need to sell before age 59 1/2. BOTTOM LINE» Equity-indexed annuities promise the best of all worlds, but it s likely that they look the most attractive and are pitched the most aggressively when investors need their protections the least. Because of their limitations on upside returns, they ll look less attractive when and if the market rebounds. They re also complicated, and the surrender charges can be enormous. As with all annuities, they promise tax-deferred growth, but you ll have to pay ordinary income upon withdrawals. Finally, equity-indexed annuities, and all other annuities, for that matter, will only be as good as the insurance company backing them. With several insurers recently in the headlines due to financial woes, I d focus on those annuities that have garnered the highest ratings from independent agencies. œ

5 Morningstar PracticalFinance March Annuities Glossary The annuity landscape is made even more confusing by the array of terms particular to the annuity industry. Here are some of the basics. Accumulation Period (or Phase) The period when the annuity holder can add money and accumulate assets tax-deferred. Annuitant The person who receives benefits from the annuity. Annuitize To begin receiving benefits from an annuity. Contract Fee Fees charged by an annuity to cover administrative expenses; usually charged annually. Death Benefit The payment made to beneficiaries if a policyholder dies before annuitizing. Equity-Indexed Annuity An annuity that provides holders with a portion of a stock market index s gain as well as a minimum return in case the market index loses money. Fixed Annuity An annuity that pays a fixed dollar amount to the annuitant. Free look period A trial period, during which time a policyholder can cancel the policy without incurring a surrender charge. Immediate Annuity An annuity that begins paying benefits within the first 13 months of initiating the policy. Immediate annuities can be fixed or variable. Joint and Survivor Annuity An annuity that pays out benefits over the life of the owner and to a designated beneficiary after the owner s death. Mortality and Expense Charge A charge that the insurance company levies to help offset the risks it s assuming. M&E charges contribute to some annuities high expenses versus investment options without an insurance component. Participation Rate The formula used to determine how much of a market index s gain holders of equity-indexed annuities will receive. Subaccount The separate investment options in a variable annuity. Subaccounts are often clones or near-clones of mutual funds. Surrender Charge The charges for withdrawing money from an annuity before an agreed-upon date. Many policies include a free look provision that allows holders to avoid the surrender charge if they cancel their policies within a certain (usually short) period of time. Term Certain Means that annuity will pay out over a specific number of years. Variable Annuity An annuity that allows the holder to select specific investments. Those investments determine the annuity s return.

6 6 Where to Go for Income Investment Insights Christine Benz Although I ve long thought that retirees should focus on total return rather than gunning for current income (and higher risks), income strategies are more relevant than ever given that many retirees are rightfully reluctant to tap their capital in the current bear market. On the following pages, I detail some of the key ways to generate current income from your investment portfolio, as well as my favorite investments for the job. For retirees, I ve long favored a total-return-oriented strategy over one focused exclusively on generating current income. For one thing, the highest-yielding securities often carry outsized risks. Moreover, some income-oriented strategies can be tax-inefficient. You ll pay your ordinary income tax rate on bond income, whereas capital gains and dividends are currently taxed at a very low rate. But tax issues aside, I think it s a pretty good time to revisit income investing. I m encouraged that you don t have to venture into outlandish securities to generate a strong yield; instead, you can earn a solid payout by investing in fairly high-quality stocks and bonds. I m not talking about 1970s-style double-digit yields, mind you, but you can easily find yields of 5% or more without taking on a lot of risk. But the more important reason to put an emphasis on income generation is that if you re a retiree, your principal has no doubt shrunk over the past year, and cutting into it further with withdrawals is probably an unappetizing prospect. As I discussed in the October issue of PracticalFinance, a retiree s best response during and after a bear market is to reduce withdrawal rates. That way you re not turning paper losses into real losses that you have no chance of recouping. If you re no longer working, the best way to cut back on withdrawals is to reduce your expenses and boost your yield. With that in mind, I ll survey the current income landscape to help identify where the most attractive opportunities are. You may remember that I also focused on income production in the March 2008 issue of PracticalFinance, but I think the market opportunities have generally improved since then. High-Quality Bonds As I ve been noting for several months now, Treasuries had, until recently, thrived at the expense of almost everything else over the past year. The net effect of that flight to quality was that even very high-quality corporate and agency-backed mortgage bonds have been depressed, thereby pushing up their yields. As of this writing, Vanguard Intermediate-Term Treasury VFITX has an SEC (30-day) yield of just 2.44%, versus nearly 6% for Vanguard Intermediate-Term Investment-Grade VFICX, and 4.6% for Vanguard GNMA VFIIX. (Ginne Mae securities are backed by the explicit faith and credit of the U.S. government, too.) Yield spreads or the yield differential between Treasuries and everything else have narrowed over the past month, but you re still getting a nice payout from many mortgage-backed and corporate bonds without taking on a lot of risk. Best Ideas As always, I d argue against venturing into individual bonds, apart from Treasuries and I-Bonds. Instead, those in search of decent bond

7 Morningstar PracticalFinance March Fund Spy $18.95 (Plus S&H) Reserve your copy today! Filled with in-depth insights and unparalleled expert advice, Fund Spy offers proven strategies to sharpen your fund-investing skills by showing you methods on how to evaluate performance, assess fund managers, and ultimately choose funds that will help you achieve your long-term financial goals. If you re serious about finding the right collection of funds, follow the guidance found in Fund Spy and you ll quickly learn what it takes to research, pick, and buy the right mutual funds. The first 500 get an autographed copy! Call toll-free: (Mention code FSPYINS9B) Visit: goto/fundspy1 yields should opt for an opportunistic core fund. Among my favorites of this ilk are the usual suspects: Harbor Bond HABDX, Metropolitan West Total Return Bond MWTRX, Dodge & Cox Income DODIX, and Artio Total Return Bond BJBGX. I m also a fan of TCW Total Return Bond TGLMX. It s a moreor-less dedicated play on the mortgage-backed bond market, so I d limit it to a small slice of one s portfolio given the obvious problems facing the mortgage sector. Municipal Bonds Just as high-quality corporate and mortgage-backed yields compare quite favorably with those of Treasuries right now, so do municipal bonds stack up reasonably well on the yield front. Munis rallied strongly earlier this year, but Vanguard Intermediate- Term Tax-Exempt VWITX still had a 30-day yield of 3.2% as of late February. That s not outrageously high, but it trumps the aftertax yield of Vanguard Intermediate-Term Treasury, even for investors in the 25% tax bracket. In fact, the spread between muni and Treasury yields was recently higher than it has ever been. Of course, Treasuries are arguably inflated, and it would be a mistake to suggest that munis are risk-free and 2008 s sell-off was wholly irrational. Munis lost ground in 2008 due in part to hedge funds unloading them en masse to pay off departing shareholders, but investors were also concerned, not unjustly, about municipalities budgetary health. Nonetheless, muni-bond defaults have historically been quite low, and the diversification you get with a municipal fund that can invest throughout the country helps mitigate potential problems in any single municipality or within a single financially troubled state like California. Best Ideas It s hard to go wrong with any of the muni funds from Vanguard and Fidelity. I d tread lightly in the high-yield municipal area, however, where defaults have historically been much higher than in the higher-quality muni space. High-Yield and Other Specialty Bonds When I wrote about income-producing securities a year ago, the yield differential between Treasuries and many specialty-bond types such as high yield and emerging markets was quite narrow. As with the aforementioned bond types, the global market downturn pounded the riskiest bonds and pushed up their yields. As of late February, many high-yield and emerging-markets bond funds, having incurred steep losses in 2008, had yields in the 10% neighborhood. Those yields are certainly tempting, but I m less sanguine about these categories than I am highquality corporates, mortgage-backeds, and munis. Defaults in the high-yield bond market have thus far been minimal, but they ve been rising steadily over the past few months and came close to 5% in January. Meanwhile, many emerging-markets countries were reliant on strong commodity prices to improve their economic wherewithal, and that in turn had boosted their bond prices for the better part of this decade. However, the global financial crisis has dramatically tamped down demand for commodities, thereby stoking economic strife and political instability in many emerging-markets countries. Best Ideas If you venture into high yield and/or emerging markets, plan to keep the position to a small slice of your portfolio ideally less than 5%. Also, I d favor the more conservatively managed funds within these categories: T. Rowe Price High-Yield PRHYX is my favorite high-yield fund, and I also like the risk-averse Fidelity New Markets Income FNMIX. Better yet, opt for a wide-ranging, bargain-hunting fund that can get in and out of these asset classes as opportunities present themselves. Loomis Sayles Bond LSBRX, while itself a fairly risky fund (look no further than its 23% 2008 loss), is a good example of what I mean. Managers Dan Fuss and Kathleen Gaffney are highly experienced, and they recently held a grab bag of beaten-down bonds, including both high-quality corporate and high-yield debt. They ve also ventured into emerging-markets debt in the past.

8 8 Dividend-Paying Stocks and Stock Funds These are challenging times for dividend investors, as financially strapped companies have been forced to cut their dividends right and left. S&P 500 companies cut their dividends by nearly $16 billion in the fourth quarter of 2008, with financial and energy firms giving their payouts the biggest haircuts. Yet my colleague Josh Peters claims that, oddly enough, he s never had an easier time finding good-quality dividend-paying stocks to buy. The reason is that the economic downturn has made it easier to separate financially stable companies that are capable of maintaining and even growing their dividends from firms that are less financially sound. At this juncture, Josh reckons, firms that are still cranking out good dividends are also on pretty sound financial footing. True, dividend yields aren t as high as bond yields, and if they are, it s often a signal that a company is severely depressed as is the case with many firms in the financial-services industry right now. Nonetheless, it s possible to find many good quality companies in the health-care and consumer staples Treasury and Municipal-Bond Yields Vanguard Intermediate-Term Tax-Exempt Inv and Intermediate-Term U.S. Treasury Inv Municipal-Bond Spread Snapshot Unattractive 1.73 Jan. 31, High Low Average p Vanguard Interm-Term Tax-Exempt p Vanguard Interm-Term U.S. Treasury Attractive Last Month ( ) A Year Ago ( ) High-Yield and Treasury-Bond Yields Vanguard High-Yield Corporate and Intermediate-Term U.S. Treasury Inv High-Yield Bond Spread Snapshot Attractive Jan. 31, High Low 2.01 Average p Vanguard High-Yield Corporate p Vanguard Interm-Term U.S. Treasury Unattractive 2.01 Last Month ( ) A Year Ago ( ) 5.26 Data as of Jan. 31, Yield Spread: The difference between yields on differing debt instruments, calculated by deducting the yield of one instrument from another. The higher the yield spread, the greater the difference between the yields offered by each instrument. For municipal bonds, a smaller spread is attractive because munis typically pay smaller yields than Treasuries. For high-yield bonds, a wider spread is more attractive because junk bonds typically pay higher yields than Treasuries.

9 Morningstar PracticalFinance March Where to Invest in 2009 Bonus! A $40 value Free As an added bonus feature to your PracticalFinance subscription, we ve created a new supplement, Where to Invest in This 34-page booklet maps out what our top analysts are saying about 2009 and some decisions you can make to diversify your portfolio, create long-term wealth, and secure your future. This booklet covers a variety of topics, that include: p Your 2009 Financial To-Do List p Retirees 2009 Survival Guide p Clip and Save: 20 Common Investing Mistakes p 10 Best Companies in the World p The Best Funds for 2009 Please Visit: to download your free copy of the booklet today! industries, both of which have recession-resistant qualities, that are yielding 3% or more. As an added bonus, many such companies offer the potential for dividend growth, and dividends currently receive more favorable tax treatment (15% for most investors) than bond income. The currently favorable dividend-tax rates are set to expire at the end of It s also worth noting that the lower dividendtax rates don t apply to every stock with a dividend yield. For example, REIT income is taxed at your ordinary income tax rate rather than at the dividendtax rate; dividends from preferred stock and certain foreign stocks (not American Depositary Receipts) are also ineligible for the lower tax rate. Best Ideas Although I d recommend that investors in search of bond yields opt for a mutual fund rather than buying individual bonds, I m comfortable recommending individual stocks for those in search of dividend yield. Of course, many financials currently have the juiciest dividend yields, but given that sector s extreme duress, I d tread lightly there and focus on the most conservatively managed firms in the sector. Three financials stocks with healthy dividends that our analysts currently like are BB&T BBT, US Bancorp USB, and Allstate ALL. Even more attractive, to my mind, are dividendpaying companies in the health-care and consumer staples sectors. These areas held up better than more economically sensitive sectors in 2008, and I think they ll continue to do so as the recession drags on. Within the health-care sector, our analysts think Johnson & Johnson JNJ is a top pick; it trades at a healthy discount to fair value and currently boasts a 3% yield. Within the consumer staples area, Kraft Foods KFT, beer and spirits maker Diageo DEO, and spice maker McCormick MKC rank high on Morningstar analysts list of 5-star companies with what we call wide economic moats. Among dividend-paying stock funds, my favorites include Vanguard Equity-Income VEIPX and T. Rowe Price Equity Income PRFDX. You ll notice that both funds, especially the Vanguard offering, have low expense ratios versus their competitors. That s important if you re gunning for current income, because expense ratios are deducted directly from your dividend yield. Both have experienced management teams and sensible, value-oriented strategies. Hybrid Stock/Bond Funds These funds come in many different varieties; most of them land in Morningstar s conservative- and moderate-allocation categories. Many of the best funds in these groups focus on high-quality bonds and sturdy, dividend-paying stocks, making them a good fit for investors seeking core funds with income and stability. Best Ideas If you buy a conservative- or moderate-allocation fund, you ve got to be sure a firm does a good job with both equity and fixed-income investing. That s a fairly short list. My favorites include Vanguard Wellington VWELX, Vanguard Balanced Index VBINX, Vanguard Wellesley Income VWINX, and Dodge & Cox Balanced DODBX. Real Estate Funds As with nearly every category I ve discussed so far, real estate securities yields have spiked over the past year as investors have cooled on commercial real estate. When I wrote about real estate last year, REIT yields weren t too far above that of Treasuries. Now, REIT yields are in the double digits in some cases. I still think there s the potential for the global market downturn to weigh on REITs through this year and beyond, however. There s also the risk that some REITs will see declining payouts as cash flows decline. Those who venture into REITs right now should prepare themselves for volatility and declining payouts, and also bear in mind that REIT yields are treated as ordinary income by the IRS. Best Ideas My favorite real estate fund, Third Avenue Real Estate Value TAREX, focuses on real estate operating companies rather than REITs, and its yield is therefore less than half of the category average. Among REIT funds, T. Rowe Price Real Estate TRREX is a solid, well-managed option. œ

10 10 Playing It Safe (but Not Too Safe) for Retirement Portfolio Makeover Christine Benz It would be hard to blame someone for feeling a bit jealous of David and Cynthia Bennett, particularly in this era of reduced nest eggs and reduced expectations. They ve both had good careers and have earned solid incomes. They ve never spent extravagantly, instead saving assiduously to fund what they hoped would be an early retirement. The spreadsheet they sent me detailing their investments was carefully categorized by investment style, along with notations about whether they hold the asset in a company retirement plan, IRA, or taxable account. Lately, however, the pair have been worrying that the market turmoil of the past year could derail their carefully laid plans. Cynthia, 60, has retired from her job as a teacher at a private school. David, also 60, is still working, but he had been planning to retire from his position as an executive at a health-care company in two years. With their investment portfolio shrinking from $2.2 million to a still-robust $1.8 million over the past year, David and Cynthia would like to be sure that their assets will last throughout what they hope will be a long retirement. They d like to be able to spend what they need to maintain their active lifestyle, do some traveling during retirement, and spend time with their grandchildren. They d also like to maintain a conservative portfolio mix for peace of mind. David and Cynthia have targeted a portfolio with a third each in stocks, bonds, and cash. Separately, David and Cynthia would also like some help streamlining their portfolio. With more than 35 individual holdings, their record-keeping is unwieldy and holding so many funds also mutes the gains from their top performers. The Before Portfolio The most notable thing about David and Cynthia s current portfolio, apart from its enviable size, is that it s far tamer than their targets for it. They currently have roughly 60% in cash, 30% in stocks and stock funds, and the remainder in bond funds. Most of their cash is in their taxable accounts. David says that he s currently investing 25% of his $200,000 salary in his 401(k), his employee stock-purchase plan, and his traditional IRA. (He earns too much to contribute to a Roth IRA.) David notes that he s been guilty of chasing mutual funds based on their short-term results, but I don t see a lot of evidence of that in the couple s current holdings. In fact, the vast majority of their mutual funds are Morningstar Fund Analyst Picks, which we select for the quality of management and strategy rather than short-term performance. The pair s equity and bond holdings skew heavily toward the Vanguard family of funds, giving their aggregate portfolio an average expense ratio of just 0.41%. What non-vanguard funds they own are among the best in their categories, including Fidelity Contrafund FCNTX, T. Rowe Price Mid-Cap Growth RPMGX, and Artisan International ARTIX. In addition, David and Cynthia hold five funds that Morningstar categorizes as conservative allocation funds that own both stocks and bonds, such as Oakmark Equity & Income OAKBX and Dodge & Cox Balanced DODBX. The pair also hold a small handful of individual stocks, including hard-hit names like Citigroup C and Ford F as well as the stock of David s employer, which lost more than half of its value last year. Overall, their portfolio is well diversified, but it skews slightly toward the value side of the Morningstar Style Box. The After Portfolio Based on scenarios I ran using Morningstar s Asset Allocator tool and T. Rowe Price s Retirement Income Calculator, I feel confident that David and Cynthia s portfolio will easily last throughout their retirement, even with a conservative asset mix and a higher spending rate than they re targeting. One of the key reasons is that David is expecting a pension payment of $3,000 per month; that payout, combined with Social Security, will fulfill much of the couple s spending needs.

11 Morningstar PracticalFinance March Streamlined and Retirement-Ready David and Cynthia s Portfolio: Before Star Category/ Holding Expense Fund Name Rating Industry Value ($) Ratio (%) Vanguard Total Stock Market Index VTSMX QQQ LB 99, Vanguard 500 Index VFINX QQQ LB 70, Fidelity Contrafund FCNTX QQQQQ LG 67, Vanguard Inflation-Protected Securities VIPSX QQQQ IB 51, Vanguard Total Bond Market Index VBMFX QQQQQ CI 46, Dodge & Cox Income DODIX QQQQ CI 41, Vanguard Wellington VWELX QQQQQ CA 37, Dodge & Cox Stock DODGX QQQQ LV 37, Company Stock QQQQQ Health 31,610 N/A Vanguard S/T T/E VWSTX QQQQ MS 28, Vanguard L/T T/E VMLTX QQQQQ MS 27, Vanguard Mid Cap Index VIMSX QQQ MB 18, Vanguard Primecap VPMCX QQQQQ LG 18, Dodge & Cox International DODFX QQQ FV 16, Cash N/A N/A 1,002,744 N/A Total (including 23 holdings not shown) 1,837,553 Super Sector Weighting (%) h Information j Service k Manufacturing Cash U.S. Stock Foreign Stock 4.87 Bonds Other 0.27 Top Three Sectors (%) i Health Care a Financial Svcs d Industrial Matls Asset Allocation (%) Equity Style (%) Value Blend Growth Large Medium Small David and Cynthia s Portfolio: After Star Category/ Holding Expense Fund Name Rating Industry Value ($) Ratio (%) Vanguard Total Stock Market Index VTSMX QQQ LB 216, Dodge & Cox Stock DODGX QQQQ LV 150, Dodge & Cox Income DODIX QQQQ CI 200, Dodge & Cox International DODFX QQQ FV 50, Vanguard Inflation-Protected Securities VIPSX QQQQ IB 100, Vanguard Total International Stock VGTSX QQQ FB 50, Vanguard Short-Term Bond Index VBISX QQQQQ CS 100, Vanguard Total Bond Market Index VBMFX QQQQQ CI 100, Vanguard Primecap VPMCX QQQQ LG 70, Loomis Sayles Bond LSBRX QQQ MU 50, Vanguard L/T T-E VMLTX QQQQQ MS 25, Vanguard S/T T-E VWSTX QQQQ MS 75, Vanguard Int/T T-E VWITX QQQQQ MI 50, Third Avenue Value TAVFX QQQ WS 50, Vanguard Windsor II VWNFX QQQ LV 19, Company Stock QQQQQ Health 31,610 N/A Cash N/A N/A 500,000 N/A Total 1,837,553 Super Sector Weighting (%) h Information j Service k Manufacturing Cash U.S. Stock Foreign Stock 9.58 Bonds Other 0.49 Top Three Sectors (%) i Health Care a Financial Svcs d Industrial Matls Asset Allocation (%) Equity Style (%) Value Blend Growth Large Medium Small Want to Be Featured in Our Portfolio Makeover? If you re interested in seeing your portfolio featured in our Portfolio Makeover section, please me at Rest assured that we will protect your privacy by using a pseudonym and withholding any other identifying details. Please include the following information: your fund, stock, and bond holdings, as well as the percentage or dollar value you have allocated to each, your age, a brief outline of your life experience, including your family situation and career background, details on the financial goals you would like to achieve, and your assessment of your risk tolerance. Categories CI Intermediate Bond CA Conservative Allocation CS Short-Term Bond FB Foreign Large Blend FV Foreign Large Value IB Inflation-Protected Bond LB Large Blend LG LV MB MI MS MU WS Large Growth Large Value Mid Blend Muni Intermediate Muni Short Multisector World Stock

12 Investment Strategy Morningstar PracticalFinance coaches you on every aspect of your financial life and provides strategies for sound investing, tax planning, and retirement. By integrating insights from other Morningstar newsletters, it shows how you can combine funds, stocks, ETFs, and other investments in a way that complements your investment style. Morningstar PracticalFinance Volume 5, Number 3 Editor, Director of Personal Finance Christine Benz Copy Editor Elizabeth Bushman, Janice Frankel Designer Mollie Edgar Senior Product Manager Jeannie Bernier Programmers Dione Branch, Sharon Leong Publisher Maureen Dahlen Playing It Safe (but Not Too Safe) for Retirement Continued from Page 10 Chief of Securities Analysis Haywood Kelly Because the Bennetts can count on so much steady income in retirement (another enviable position to be in), they can feel confident deploying some of their cash. As has been a theme in recent Portfolio Makeovers, I think bonds represent a happy medium for this couple. Given that they ll be deploying some of their cash from their taxable accounts and the fact that they re in the 28% tax bracket, I d recommend adding to their municipal-bond funds. Vanguard Intermediate-Term Tax-Exempt and Vanguard Short-Term Tax- Exempt are both well-managed municipal-national funds that don t venture heavily into risky credits. If the Bennetts amass more than $1,000,000 with Vanguard, they ll qualify for the firm s Flagship service, which entitles them to free financial-planning advice, among other perks. To help fulfill the couple s secondary goal of streamlining, I d cut their moderate-allocation funds, including Dodge & Cox Balanced, T. Rowe Price Capital Appreciation PRWCX, Fidelity Balanced FBALX, and Oakmark Equity & Income. Nearly all are terrific funds, but they re redundant with some of the pair s other holdings. I would also recommend that David and Cynthia sell some of their struggling individual stocks and book tax losses. In addition, the pair should consider paying their mortgage down more aggressively than they have been. In fact, given their conservative asset mix, retiring that debt might provide a bigger bang for their buck than investing in bonds. They currently pay $1,725 per month to service their mortgage and have 10 years left on their loan. I d recommend ratcheting up that payment by at least a few hundred dollars a month. In so doing, they ll be on track to retire worry-free. œ Contact Christine Benz at Managing Director Don Phillips 2009 Morningstar, Inc. All rights reserved. Reproduction by any means is prohibited. While data contained in this report are gathered from reliable sources, accuracy and completeness cannot be guaranteed. The publisher does not give investment advice or act as an investment advisor. All data, information, and opinions are subject to change without notice. Reprints of articles and information appearing in Morningstar PracticalFinance are available in quantity For inquiries regarding your subscription, contact: Address editorial questions and submit portfolios for consideration to Christine Benz at Morningstar PracticalFinance is published monthly by Morningstar, Inc., 22 West Washington Street, Chicago, IL For address changes, please call our product support line at For subscriptions call: toll-free Subscribers: Download Morningstar PracticalFinance Early Want to get next month s PracticalFinance even earlier? Go to to get a free electronic copy. This electronic copy will be available on the 5th of the month. We are providing this electronic copy free of charge to all of our customers in addition to the normal printed copy, which will arrive in the mail. The Web address will change every month as we put up the most current issue, so keep looking here for the most up-to-date address. Application to mail at Periodicals Postage rates is pending at Chicago, IL and at additional mailing offices. POSTMASTER: Send address changes to Morningstar PracticalFinance, 22 West Washington Street, Chicago, IL MPF This publication is printed on Cascades Rolland ST 30 paper, which contains 30% postconsumer waste fiber and is manufactured using biogas energy.


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