Preparing a Portfolio for Retirement

Walter and Wilma Ludwig (not their real names) are just starting down the road of what they hope will be a long and happy retirement. Walter, 65, recently retired from a major manufacturing firm, and Wilma, 68, sold her small retail business a few years ago.

Both plan to work part-time through this year to supplement the income they're currently receiving from Social Security and Walter's small pension.

The pair, who don't have children, plan to fully retire in 2010. They love to travel, and they're looking forward to spending more time at their vacation apartment in Europe.

Like many retirees, they have seen their portfolio battered by market storms over the past year. After watching the equity funds in his 401(k) plan plummet by 48%, Walter recently moved his 401(k) assets into a cash/cash-equivalent fund. As a result of this shift, roughly two thirds of the pair's assets is now in cash or cashlike assets. That big cash position has provided peace of mind and cushioned their portfolio recently, but Walter and Wilma are concerned about their portfolio's ability to last through their retirement years if it's earning only a meager rate of return.

They're looking for guidance on how to improve their portfolio's upside potential while keeping it on a fairly even keel. And while they're not currently tapping their retirement assets for living expenses, they'd also like help establishing a portfolio and withdrawal strategy for when they do retire in 2010.

Walter and Wilma's Portfolio--Before
Holding	Value ($)
Can Slim Select Growth	2,234
T. Rowe Price Eq Inc	88,614
Weitz Value	1,784
Fidelity Contrafund	12,374
Bridgeway Aggressive Inv	5,333
Dodge & Cox Income	13,502
Fairholme	6,969
iShares MSCI Emer Mkts	12,600
Perkins Sm Cap Value	1,449
Cash	255,141
Total	400,000

Cash takes up roughly two thirds of the Ludwigs' portfolio currently, and the rest of the assets are primarily invested in stock funds. The pair has a relatively small position in a single bond fund,  Dodge & Cox Income . In all, their portfolio is notably light on bonds and bond funds given the couple's ages and life stage.

In addition, the couple's two homes, which together have a value of more than $1 million, take up a substantial portion of their net worth. They don't hold mortgages on either property. Walter says that they plan to sell their primary residence, currently valued at roughly $800,000, within the next three years and buy a condominium or apartment for approximately $250,000 to $300,000.

Walter and Wilma have just nine long-term mutual funds in their IRAs and taxable account, making their portfolio positively svelte relative to those of most other couples at their life stage. Nearly all of their funds are  Morningstar Fund Analyst Picks. The pair's equity portfolio has a strong bias toward the value column of the Morningstar Style Box, however, and it also has a bigger emphasis on small- and mid-cap stocks than is the case with the broad market. In addition, the couple's portfolio lacks exposure to developed foreign markets. Their sole international holding is  iShares MSCI Emerging Markets .

Walter and Wilma's Portfolio--After
Holding	Value ($)
Dodge & Cox Income	100,000
T. Rowe Price Eq Inc	30,000
Fidelity Contrafund	40,000
Vanguard Short-Term Bd Idx	30,000
Perkins Small Cap Value	20,000
Fairholme	25,000
Tweedy, Browne Global Val	20,000
Vanguard Inflation-Prot Sec	35,000
Cash	100,000
Total	400,000

Job one for the Ludwigs is to move some of their cash off of the sidelines. Their equity allocation seems reasonable for now, but I'd recommend that Walter and Wilma deploy a sizable portion of their cash position into bonds. As I've written in the past few months, I think bonds represent a terrific happy medium for investors who are nervous about the current market environment but worried about missing out on a rebound. Corporate and mortgage-backed bonds are arguably still trading cheaply relative to Treasury bonds right now. The Ludwigs' fixed-income fund, Dodge & Cox Income, is a fine core bond fund that includes exposure to both sectors. I would also recommend smaller positions in  Vanguard Inflation-Protected Securities and  Vanguard Short-Term Bond Index . Enlarging their bond position will also increase their portfolio's income stream when Walter and Wilma begin taking withdrawals from their retirement accounts.

I like all of the Ludwigs' stock funds, but their core holdings should take up a bigger share of their portfolio, and I'd like to see more balance between value and growth. Thus, I'd enlarge their position in  Fidelity Contrafund . I would also recommend jettisoning the dedicated emerging-markets ETF and instead building a position in a broad international fund that focuses primarily on developed markets.  Tweedy, Browne Global Value is one of my favorite picks for retirees.

To help enact these changes, I'd recommend that Walter roll over his 401(k) plan into an IRA, to allow for many more investment choices than are currently available to him in his 401(k) plan. Because the Ludwigs have a big share of their net worth tied up in the value of their homes, I was encouraged to hear that they're planning to downsize to a smaller home within the next few years. In so doing, they'll free up roughly $500,000 to $550,000 in investable assets. Of course, the decision about whether to downsize is a personal one based on factors both financial and nonfinancial. In this case, though, selling the home will greatly improve the chances that Walter and Wilma's portfolio will last throughout their retirement. Once they have the cash from their home sale, the Ludwigs should deploy the assets proportionately across their holdings.

Walter and Wilma haven't yet begun to withdraw assets to pay living expenses, but when they do, they should start with their taxable accounts. For that reason, they should reposition their taxable holdings, which are currently stock-heavy, to encompass cash and other fairly liquid securities. Once they sell their primary residence and have the cash in hand, they should have an easy time meeting their income needs of $60,000 per year with a combination of Social Security, Walter's pension, and a withdrawal rate from their portfolio totaling 3% per year.   

Read more on retirement plan rollovers, estate planning, annuities, and more in Morningstar's Retirement Center

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