How to maximize your take-home payout.
By Christine Benz | 09-06-05 | 06:00 AM | Email Article

One story that has gone underreported in the popular press is just how challenging the past several years have been for those investing during their retirement. Sure, we've all read horror stories about retirees who were forced to return to work because they had staked their whole nest egg in Enron stock. But even those seniors who didn't make big portfolio mistakes have been quietly fighting an uphill battle over the past several years. Investors have been lucky to earn a 5% yield from bond funds, and the bear market of 2000 through 2002 provided a stark reminder of the perils of staking too much of a portfolio in stocks.

Christine Benz is Morningstar's director of personal finance and author of 30-Minute Money Solutions: A Step-by-Step Guide to Managing Your Finances and the Morningstar Guide to Mutual Funds: 5-Star Strategies for Success. Follow Christine on Twitter: @christine_benz.

Things won't get better overnight, but some relief is in sight. Rising interest rates, while a bane for those assuming new mortgages and car loans, offer the promise of higher bond payouts to come. In the meantime, here are some tips for maximizing your portfolio's income stream.

1. Pinch pennies.
Readers often chide Morningstar analysts for making too much out of mutual fund expenses. But low costs are absolutely crucial when it comes to bond funds. That's because a mutual fund's expense ratio is deducted directly from its yield, so there's a direct relationship between a lower expense ratio and the potential for a fatter income payout. Morningstar studies have also shown that higher-cost bond funds often take on more risk in an effort to compensate for their expenses.

Look for bond funds that charge less than 0.75%--preferably much less. Morningstar's  Fund Analyst Picks list provides a stellar lineup of offerings that clear that hurdle; among my favorite core bond funds include  Vanguard Total Bond Market Index  (yep, indexing makes just as much sense for bonds as it does for stocks) and  Metropolitan West Total Return Bond .

And while I'll be the first to concede that paying for high-quality financial advice can be money well spent, you'll also want to think carefully before paying a sales charge for a bond fund. If you're paying a 3.75% load to buy a bond fund (and that's a pretty low load), you're surrendering most of your first year's income payments from the get-go. Morningstar's  Cost Analyzer can help you compare the total costs associated with various load and no-load funds. (Analyst Picks and Cost Analyzer are available to Premium users of; for a free trial subscription, click here.)

2. Don't forget about total return and risk.
Many retirees focus on income, and it's easy to see why. If you're living off your portfolio, it's certainly preferable to tap your investment earnings rather than dig into your principal. But it's a mistake to overlook total return and risk when selecting any investment. That's because total return is a more inclusive figure than yield (it encompasses income plus any increase or decrease in the value of a portfolio's securities) and it's therefore your bottom-line gauge of whether a fund is worthwhile or not. In fact, many top bond managers--including PIMCO's Bill Gross--focus exclusively on total return when managing their portfolios.

In a related vein, when choosing an income-producing investment, it's a mistake to disregard its risk. Some bond funds offer enticing payouts but may take big chances to do so, including venturing into lower-quality and longer-duration credits; if your funds' bonds lose value, you could see your principal shrink even though you're pocketing a healthy yield. Checking a fund's quarterly losses--found on the Total Returns page of a fund's Analyst Report on be an easy way to see whether you could stomach a given fund's short-term losses.

Of course, there's nothing wrong with making room for some higher-yielding bond funds--including high-yield ("junk") and international vehicles--around the margins of your portfolio; I'm also a fan of so-called floating-rate funds, which invest in bank loans and generally offer plump yields without taking on a lot of interest-rate-related risk. But consider these income-heavy funds to be side dishes, not entrees, because of their greater potential for volatility.

3. Investigate munis.
Although many investors assume that municipal bonds are strictly for the ultra-rich, that's not necessarily so. Even if you're not in the highest income bracket, a municipal-bond fund's yield may beat a taxable fund's payout once taxes are factored in. (Income from municipal bonds is free from federal--and in some cases state--income tax.) Here's an example:  Fidelity Municipal Income  currently yields 3.44%, while  Fidelity Investment-Grade Bond  has a payout of 3.90%. But once you take the tax collector's bite into account, Fidelity Municipal Income is the better bet: Even investors in the 15% tax bracket would pocket a higher aftertax yield by investing in the muni fund than they would the taxable offering.

Turn to Morningstar's Bond Calculator to help determine whether you're better off investing in a municipal-bond or taxable fund. If you opt for the former, Morningstar's  Fund Analyst Picks list includes a host of the best muni funds, from core intermediate-term funds to high-yield and short-term vehicles; Fidelity's are among my favorites.

4. Don't rule out stocks.
Income-oriented investors typically focus on bonds, and that's been particularly true over the past several years, as the dividend yield on the S&P 500 Index has shrunk to less than 2%. Nonetheless, stocks and stock funds with meaningful dividend yields can help balance out a bond-heavy portfolio by providing diversification and greater potential for capital appreciation. Stock dividends also receive more favorable tax treatment than do bond payouts: They're taxed at 15% currently (even less if you're in a lower tax bracket), whereas bond income is taxed at your ordinary income tax rate.

Morningstar doesn't have a separate category for income-oriented stock funds, but most offerings that target dividend-paying stocks tend to land in Morningstar's mid- and large-cap value categories. As with bond funds, you'll want to prioritize low costs, because a stock fund's expenses are deducted from dividend yield. Among my favorite income-producing stock funds are  Vanguard Equity-Income  and  iShares Dow Jones Select Dividend Index , an exchange-traded fund.

5. Get the most out of your short-term holdings.
Although I'm a big fan of ultrashort-term bond funds, right now I'd urge investors to check out CDs or money market funds for all or part of their cash holdings. Such vehicles are typically the first to reflect a change--for better or for worse--in prevailing interest rates, and the recent round of Federal Reserve interest-rate hikes has resulted in the richest money market and CD yields in years. Click here for some pointers about how to wring the most return from your cash holdings, and check out this article for the lowdown on Morningstar's favorite money market funds.

6. Opt for funds rather than individual securities.
Many investors prefer to invest in individual bonds rather than bond funds. While that's a reasonable tack if you're buying Treasury securities or perhaps even extremely high-quality corporate bonds, it makes sense to opt for a professionally managed bond fund for every other type of fixed-income security. Not only will a mutual fund offer you much more diversification (and therefore lower risk) than you could obtain by buying individual bonds, but smaller investors who are buying and selling individual bonds are also at a big disadvantage when it comes to trading costs. Click here to read my colleague Eric Jacobson's article about the factors to bear in mind when deciding whether to opt for individual bonds or a bond fund.

Securities mentioned in this article



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Christine Benz does not own shares in any of the securities mentioned above. Find out about Morningstar's editorial policies.
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