A Model Portfolio

(Dow Jones) In light of last year's brutal market crash, it's more important than ever for retirees and those nearing retirement to prepare a strategy for withdrawing money from their nest eggs, say financial planners at Mason Investment Advisory Services Inc.

Mason's advisors have been talking a lot lately with clients about reasonable rates of withdrawal and investment strategies that can help make their savings last for a retirement that could be 25 or 35 years long. "If an investor is going to stick with a program, you need to set their expectations properly," says Scott George, chief investment officer of the Reston, Va., firm. The firm, founded in 1982, manages about $1.7 billion for its clients, primarily very wealthy individuals and nonprofit organizations.

Mason's director of research, Thomas Pudner, recently studied the performance of a few different types of portfolios over periods of five, 10, 25, 35 and 50 years from 1926 through July 2009, to see how well each would have provided a hypothetical client an annual withdrawal of $40,000, adjusted for inflation or deflation, given $1 million to start with.

Inflation clobbered the portfolio holding only intermediate-term government bonds. Looking at rolling 25-year periods, this portfolio would have sustained the target withdrawal for only a third of them. A portfolio 65% in stocks and 35% in bonds would have met the target over 93% of the 25-year periods and 73% of rolling 35-year periods.

The best results, Mr. Pudner found, would have come from a broadly diversified portfolio that included real estate and commodities. Such a portfolio would have almost always met the withdrawal target, for all of the time periods considered. To be sure, some of these investments, such as commodities, weren't available to individuals until recently.

In talking to clients, the Mason advisors recommend limiting withdrawals to around 4% of their portfolios a year or less. During the market boom of 2006 and 2007, some clients became very optimistic and increased their withdrawals to 6%, says Christopher Schreiner, Mason's chief operating officer. Now, they're cutting back, he says. This is happening "regardless of income levels," says Schreiner.

The advisors typically recommend that clients go with the broadly diversified model portfolio. Some clients would prefer to load up on what they see as conservative investments, such as bonds. This is actually risky, says George, because "you up your probability dramatically of outliving your money."

Individuals who want to be more conservative are offered two alternatives: delay withdrawals by some years, possibly by taking up a part-time job, or withdraw less money in the first few years. Schreiner says a number of clients are choosing to delay retirement, while some have decided not to leave an inheritance for their children.

Here the Mason advisors share their model diversified portfolio, suitable for a client in retirement. This portfolio was up 25% through Nov. 30, net of all fees. Nearly 60% of Mason's clients use this type of portfolio. Its weighted average expense ratio is 0.62%; in addition, clients pay an advisory fee to Mason typically ranging from 0.5% to 1% of assets.

U.S. STOCKS: Thirty percent of the portfolio is in U.S. stocks, with roughly three-quarters of that in mutual funds that buy large-company stocks and the rest in small-stock funds. The advisors also divide this portion of the portfolio among "value" funds, whose managers buy stocks that they consider cheap based on the companies' earnings, and "growth" funds, which buy stocks that typically are pricier because the companies' earnings are growing rapidly. Looked at this way, 19% of the overall portfolio is in U.S. value-oriented funds and 11% is in U.S. growth funds.

For the most part, the advisors use at least two funds in each asset class, which is why the portfolio has holdings in nearly 30 funds. "We do end up owning a large part of the market," says George, the chief investment officer. He believes all these funds are needed to achieve the desired diversification. He says the advisors aim to choose funds that invest differently even in the same asset class and so could perform differently in various market conditions.

For instance, they dedicate a total of 14% of the portfolio to three funds that focus on large U.S. value stocks: Davis New York Venture, T. Rowe Price Equity Income and Vanguard Value Index. "The three of them complement each other for returns and for volatility," says George. In some market conditions, one might perform better than the others.

The advisors, however, note that individuals who are building their own portfolios may find it tough to research a large number of funds and figure out the differences. "You're better off buying a few funds that you know what they're doing and they're diversified," says Mr. Pudner, the research director. Also, for individuals, it can turn out to be very costly and unwieldy to keep track of a large number of funds.

The team at Mason uses mostly actively managed funds. "Up until last year, we found good active managers do very well in a down market," says George. "Last time around, all bets were off." The advisors use some index funds and ETFs also, to get additional exposure to some asset classes.

For large growth exposure in the U.S., the advisors invest 4% each in American Funds Growth Fund of America and Jensen Portfolio. The 8% allocation to small-company stocks goes to two value funds, Vanguard Small-Cap Value ETF and Berwyn Fund, and two funds that are more growth-oriented, Dreyfus/Boston Co. Small Cap Tax-Sensitive Equity and Conestoga Small Cap.

FOREIGN STOCKS: The portfolio's 15% foreign allocation is mostly in funds that buy stocks of large companies in developed countries. These include Dodge & Cox International Stock and Vanguard International Value, at 4% each, 3% in American Funds EuroPacific Growth and 2% in William Blair International Growth. Another 2% of the portfolio is in the SPDR S&P International Small Cap ETF, which buys small foreign stocks.

The advisors don't use a dedicated emerging-markets fund because they find them to be too volatile for their clients' appetite.

BONDS: The 35% portion of the portfolio allocated to bonds and cash is primarily in U.S. bonds of varying maturities. Seven percent is in funds that currently own bonds that mature in less than five years -- Vanguard Short-Term Investment-Grade and FPA New Income. For intermediate-maturity bonds, the advisors use Harbor Bond and Dodge & Cox Income, at 4% each, and for long-term bonds they invest 4% in Loomis Sayles Investment Grade Bond and 3% in Vanguard Long-Term Investment-Grade.

Earlier this year, the advisors started investing 6% in the Vanguard Inflation-Protected Securities bond fund. There is also a 5% allocation to foreign bonds, through Pimco Foreign Bond (U.S. Dollar-Hedged) and T. Rowe Price International Bond.

ALTERNATIVES: Of the remaining 20% of the portfolio, 11% is in funds that own real-estate securities -- Cohen & Steers Realty Shares and ING Global Real Estate.

The advisors kept buying those funds in the fall of 2008, even when they were losing value, in order to maintain their target allocations. "We have stuck to our guns," says Mr. Schreiner, the chief operating officer. The advisors believe that over the long run, real-estate investments help diversify a portfolio and reduce its volatility.

For their energy and commodity allocation, the advisors use Pimco CommodityRealReturn Strategy at 4% of the portfolio, Vanguard Energy at 3% and Columbia Energy & Natural Resources at 2%.