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A power portfolio for the about-to-retire
A bond-heavy strategy has little margin to compensate for error or inflation. Heres a two-pronged plan that will preserve your purchasing power for decades to come.
By Timothy Middleton
If youve just settled into your retirement nest, or expect to shortly, its time to take a fresh look at your investments. As I explained in a recent column, traditional retirement planning can lead to disaster if you outlive your plans.
That column, which recommended an equity-heavy approach to the topic, generated a spate of e-mails, many of which could be summarized like this: Are you #?^@*&! nuts? The conventional wisdom, with its heavy emphasis on fixed income, is obviously still in vogue.
But a larger number were in the vein of this from Cathy Wendt: Please tell me the rest of what you do -- for example, where you put (the investments) and when you start the four-year (bond) laddering.
Happy to oblige, and it wont take long, because what I call my Power Retirement Portfolio consists of only two parts. The first is Treasury bonds; if theyre too risky for you, use your money as a mattress. The second is T. Rowe Price Capital Appreciation Fund (PRWCX). The last time this market-beating fund lost money my now-grown kids still thought I was a god because I was taking them to Disney World.
This fund has consistently provided positive returns, often in the double digits, over the past 10 years, including a 22.2% return in 2000, says Michael Allegretti, a technology consultant for the United Nations in New York who owns it as the core of his retirement portfolio. With low costs and a (13.2%) 10-year annualized return, I think this fund definitely qualifies as a winner in any market.
A reliable income stream
The basic approach I described in my earlier column, based on the advice of John Heinlein, a financial adviser in Towson, Md., is to combine a reliable stream of income with a growth portfolio of common stocks that'll keep the financial pipeline filled.
For income, Heinlein recommends a four-year ladder of high-quality bonds. Bond mutual funds aren't suitable for this purpose. Unlike individual bonds, they never mature so youre not guaranteed to recoup your principal.
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Heres how I'd build such a ladder, using the example of a $500,000 portfolio designed to deliver $30,000 annually in current purchasing power for decades.
I'd take $111,534 of the kitty today and buy Treasury strips, or zero-coupon notes, maturing one, two, three and four years from now. These are conventional government bonds that Wall Street has stripped of their interest payments (which are sold to others); you get back their face value at maturity.
The strips maturing in May 2005 are priced currently at 98.12% of face value; that is, $30,000 worth would cost $29,436. Note that these prices are market quotes for $1 million blocks of such bonds; you could actually pay slightly more at a bank or brokerage to buy in smaller quantities. When this bond matures, you get a check for $30,000.
At the same time, I would buy strips maturing in 2006 ($28,548), 2007 ($27,378) and 2008 ($26,172). This way, I am guaranteed an annual income of $30,000 in each of the next four years, no matter if markets crash or soar.
Another option
Of course, you could buy other Treasury bonds to accomplish the same end, including bills and notes that you can buy directly from the Treasury without paying any commissions. That would take slightly more capital -- $120,000 in all -- but would also produce a bit more income. The zero-coupon notes generate the least complicated math.
I'd invest the remaining $388,466, which is 77.7% of my capital, in T. Rowe Price Capital Appreciation. I've chosen it for many of the reasons I cited in another recent column regarding low-risk, high-return funds that, as Allegretti says, win in any market.
The only annual loss this fund has suffered since its launch in 1986 was a 1.2% slippage in 1990. This is despite having a majority of its assets invested in the stock market, which historically has produced the highest investment returns.
Currently, the fund is about 65% stocks, with the balance divided between cash and stocklike convertible securities. The fund will sometimes own bonds but doesnt now because of concerns about their vulnerability to rising interest rates.
Our cash position (20%) is a hedge against the bond market, rather than the equity market, says Steve Boesel, the funds manager. The stock holdings are at their high end, historically, because Boesel is still bullish on the ability of corporations to produce earnings above the markets expectations.
Nice numbers
The funds expense ratio is a below-average 0.85% of assets and its turnover a thrifty and tax-efficient 18%.
The funds stock holdings are an eclectic mix of often distressed companies. According to the funds most recent portfolio report these include Newmont Mining (NEM, news, msgs), Amerada Hess (AHC, news, msgs), Newell Rubbermaid (NWL, news, msgs), Loews (LTR, news, msgs) and Ryder System (R, news, msgs).
The broadly diversified and somewhat contrarian fund has its heaviest weightings in materials, financials and consumer discretionary stocks, with lesser allocations to services, energy and health care.
Capital Appreciations double-digit performance has persisted over the last one, three, five, 10 and 15 years, and Morningstar calculates that since inception returns have averaged 13% annually. If, in the interest of caution, you assume average future returns of 10.5%, closer to the markets traditional level, over the next four years your capital could grow to $579,314.
At that time you would pull 22.3% of that sum, or about $130,000, to buy another ladder of bonds that would increase your income stream to about $35,000 annually, to compensate for inflation.
Margin for error
In this scenario, your retirement income goes up with the consumer price index while your capital increases as well. In reality, future adverse markets could shrink these numbers, but this model has sufficient margin for error to allow you to maintain your current spending power for more than 20 years, at least.
A retirement portfolio overweighted with bonds, contrariwise, has no margin of error. If you were to use your $500,000 to buy bonds generating $30,000 a year, at a 2% inflation rate your purchasing power in 20 years would be about $20,500 -- a one-third reduction in your standard of living.
You dont have to buy the T. Rowe Price fund to implement this strategy; other excellent fund candidates can be uncovered with a little research. Heres a screen from our Deluxe Fund Screener to start you on your way.
At the time of publication, Timothy Middleton didnt own any securities mentioned in this article.
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