Over a lifetime of investing, soon-to-be retirees may find themselves with a hodgepodge collection of mutual funds. When combining them together to see the asset allocation for the total portfolio, this collection of funds may be far away from what the retiree has in mind or finds acceptable. As well, these funds may have been purchased from a variety of brokers (none of whom was familiar about the other funds already in the portfolio), and may have high annual fees and loads, and which may have deeper underlying fees associated with the transaction costs and high turnover of actively managed funds. High turnover also leads to higher taxes. As John Bogle teaches, all of these costs work together to prevent investors from getting their fair share of the returns offered by the markets.
For many, it may make a lot of sense to sell these miscellaneous funds and essentially start over with a company that provides low-cost diversified index funds, such as Vanguard. (This is not a paid advertisement and there are other companies which could be used too, but as I am a customer of Vanguard, I am most familiar with their offerings and will use them for my discussion).
With a few hours of effort, the paperwork can be filled out open a Vanguard account and to transfer IRA assets there. For taxable accounts, matters are more tricky as selling the old funds may trigger large taxes on capital gains. In this case, the process may have to be gradual and may have to wait for years where the marginal tax rate will be lower. Also, be careful if some of those old funds charge loads when sold.
The idea of moving the assets to Vanguard is to get your finances organized. Get your assets into a few low-cost and diversified index funds to give you exposure to US stocks, international stocks, and bonds. I can’t tell you an appropriate asset allocation, as this depends on your personal circumstances and your capacity and tolerance to accept portfolio volatility. But I can explain some of the different approaches you can use to put together a portfolio with Vanguard funds. A well-diversified portfolio can be obtained with anywhere from one to five funds.
For a lot of the following cases, there are also similar ETFs, and Vanguard also offers even lower-cost Admiral shares for those with sufficient assets invested. But to simplify the discussion, I will only refer to the regular mutual fund offerings.
Here are 6 different strategies to consider when building a retirement income portfolio with Vanguard mutual fund offerings:
(1) Vanguard Target Retirement Date Funds: This approach offers a one fund set-it-and-forget-it approach. With a set target date, Vanguard automatically adjusts the asset allocation over time to reduce volatility and provide income as the target date approaches and passes. Funds range in 5 year increments from Target Retirement 2010 (VTENX) to Target Retirement 2060 (VTTSX). They also have another fund called Target Retirement Income (VTINX) which you can purchase separately. About seven years after the target date, the other funds are rolled into the Target Retirement Income Fund anyway. Of the various approaches I’m describing, this is the only approach which includes a TIPS component. However, this is also a one-size-fits-all approach, and you do have to decide if their idea for an appropriate asset allocation for retirement income matches your own ideas about this.
(2) Total Market Index Funds: This approach is a bit more complicated than the target date funds, because it requires you to own multiple funds and to continue monitoring your asset allocation, to rebalance, and to decide from which funds to withdraw. But for those who are more interested to manage their investments, this piece-by-piece approach does provide greater flexibility to customize your asset allocation so it fits your personal circumstances better. If you have very little interest in following your investments, this is not the approach for you. There could be other possibilities as well, but three basic funds which could be used to build a portfolio with this approach are the Total Stock Market Index Fund (VTSMX) for US stocks, the Total International Stock Index Fund (VGTSX) for international stocks, and the Total Bond Market Index Fund (VBMFX) for US bonds.
(3) LifeStrategy Funds: These are a series of balanced portfolios with fixed allocations of low-cost index funds with different underlying objectives. They are similar in nature to target date funds, except that the asset allocations do not change over time. These funds also provide a way to get more aggressive or conservative asset allocations than the one-size-fits-all target date funds. These funds basically provide an alternative way for having Vanguard take care of the rebalancing for a broadly diversified portfolio of the total market index funds described in (2). Options include LifeStrategy Conservative Growth (VSCGX), LifeStrategy Growth (VASGX), LifeStrategy Income (VASIX), and LifeStrategy Moderate Growth (VSMGX).
(4) Managed Payout Funds: These are a new patent-pending approach taken by Vanguard, which pays distributions based on dividend income, capital gains, and possibly some return of capital. They can provide a source of retirement income, aim to preserve or grow principal, and each payout fund has a slightly different focus. The Vanguard Managed Payout Distribution Focus Fund (VPDFX) seeks to preserve capital by providing income from dividends and capital gains, though in years with portfolio losses some of the payout may come from principal. Currently (as of July 23, 2012), each share pays out 0.56% of its share price per month. The Managed Payout Growth and Distribution Fund (VPGDX) aims to preserve the inflation adjusted value of initial capital and currently pays out 0.39% of its share price per month. The payout is lower in part because the capital preservation needs are higher. Finally, the Managed Payout Growth Focus Fund (VPGFX) is more focused on preservation and currently pays out 0.22% of its share price per month. Due note that there are no guarantees associated with their income and growth objectives, and while these can provide a good approach to obtaining retirement income, they are still relatively new and complicated, and you should definitely study more about this option. The Vanguard webpage notes potential complications with taxes, use in tax-deferred accounts, and also issues with not matching the IRS required minimum distribution rules for tax-deferred accounts. To be honest, with the higher fees and newness of the Managed Payout Funds, I would be a bit more cautious myself about using them at this point, but they are worth watching and knowing about.
(5) Dividends and Interest: Though it is rational to focus on a total returns perspective and not worry about whether some income comes from principal, many retirees may feel more comfort by spending only dividends and income from their portfolio. With this approach, they may like funds which tend to provide more of such dividends and income, even if that means that capital gains may be less in a bull market. The Vanguard High Dividend Yield Index Fund (VHDYX) is a stock fund indexed to higher-than-average dividend stocks. The Vanguard High-Yield Tax-Exempt Fund (VWAHX) may be good for a taxable portfolio and focuses on higher yielding municipal bonds (which also have higher credit risk).
(6) The Classics: These are two low-cost but active (rather than indexed) funds with long histories and a balanced approach, either of which could serve as a core holding in the retirement income portfolio. Wellesley Income (VWINX) is a balanced fund which focuses on dividend stocks (1/3) and investment-grade bonds (2/3). The Wellington Fund (VWELX) began in 1929 and is the oldest balanced fund with stocks (2/3) and bonds (1/3).
The bottom line
I think you can’t really go wrong with any of the outlined approaches here. To make a final decision, two important considerations are what your appropriate asset allocation is, and also how actively involved you wish to be in managing your investments.