An annual survey by Pensions & Investments and Towers Watson & Co. (TW) looks at the world’s 300 largest retirement plans. In early September, P&I revealed that the assets of these plans grew by 9.8% in 2012, the fourth consecutive year of gains.
So what do these plans look like? Well, the top 20 plans — which account for 39% of the top 300′s $14 trillion in total global assets — invested 40% in equities in 2012, another 40% in fixed income and the remaining 20% in alternatives and cash.
If this asset allocation is good enough for the world’s biggest retirement plans, it should be good enough for the average investor. And you can build such a retirement portfolio using just a few exchange-traded funds:
First, let’s focus on the largest retirement fund in America — the Thrift Savings Plan, a defined contribution plan for federal employees. Plan holders have a choice of five individual funds — two that would be considered fixed income and three that are equity — that can be invested independently or within a target-date fund ranging in need from today through 2050.
The three equity funds track the S&P 500, the Dow Jones U.S. Completion Total Stock Market Index and the MSCI EAFE Index.
S&P 500 Exposure — Vanguard S&P 500 ETF (VOO): When it comes to the S&P 500, there are three standard choices: the SPDR S&P 500 ETF (SPY), iShares Core S&P 500 ETF (IVV) and the Vanguard ETF, the VOO. With little difference between the three, I’ll go with the VOO because it has the cheapest expense ratio at 0.05% annually.
Dow Jones U.S. Completion Total Stock Market Index Exposure — Vanguard Extended Market ETF (VXF): The Completion index represents all U.S. equities with readily available prices — excluding the S&P 500 — for a total of 3,136 stocks. Unfortunately, no ETF tracks this index, but again, a Vanguard ETF fits the bill. The Vanguard Extended Market ETF tracks the S&P Completion Index, which is essentially the same thing. VXF’s median market cap is $3.3 billion, putting it nicely in the mid-cap category. In business since December 2001, VXF’s total net assets are $2.4 billion and its expense ratio is a very reasonable 0.14%.
MSCI EAFE Index Exposure — db X-trackers MSCI EAFE Hedged Equity Fund (DBEF): The final piece of the equity puzzle is to select an ETF that replicates the MSCI EAFE Index, a group of 909 mid- and large-cap stocks from 22 developed markets excluding Canada and the U.S. The U.K. and Japan combined account for almost 44% of the index’s composition, and the median market cap is $6 billion — significantly larger than S&P Completion Index, but much smaller than the S&P 500.
To mitigate currency risk, I’ve chosen the db X-trackers MSCI EAFE Hedged Equity Fund, a hedged version of the index. DBEF holds 594 stocks and charges 0.35% annually, which is more than reasonable given the hedging activity. Year-to-date through Oct. 7, the fund has achieved a total return of 17.1% — 178 basis points greater than the index itself. However, it’s important to remember that when the U.S. dollar depreciates (it has appreciated in 2013 against major currencies), DBEF’s performance will trail the index. I’ve chosen this ETF to even out performance over the long-term.
Now, let’s move on to fixed income.
The Thrift Savings Plan has two options for fixed income. There’s the G Fund, whose objective is to generate interest income without risking the principal. Then there’s the F fund, which seeks to replicate the performance of the Barclays Capital U.S. Aggregate Bond Index, representing the broad U.S. bond market and consisting of high-quality fixed-income securities with maturities of more than one year.
Short-Term Bond Exposure — SPDR Barclays 1-3 Month T-Bill ETF (BIL): The G Fund invests in short-term U.S. Treasury securities that are issues specially made for the TSP, so there is no specific benchmark. However, a suitable proxy would be the Barclays Capital US 1-3 Month Treasury Bill Index, which includes all publicly issued zero-coupon US Treasury Bills that have a maturity of less than three months and more than one month, are investment-grade and have $250 million or more outstanding. The SPDR Barclays 1-3 Month T-Bill ETF is a collection of eight T-Bills that don’t pay a whole lot but generally preserve capital fairly well. The big thing to worry about is inflation suddenly whipping up. However, with a time frame of less than three months, the risk is minimal.
Medium-Term Bond Exposure — iShares Core Total U.S. Bond Market ETF (AGG): With four obvious choices from Vanguard, State Street (STT), iShares and Schwab (SCHW), I’ll go with the iShares Core Total U.S. Bond Market ETF (AGG), which has 1,961 holdings providing a 12-month yield of 2.39%. AGG has total net assets of $14.4 billion, and since inception in 2003 it has achieved an annualized total return of 4.5% and never fallen in the red. That’s the beauty of bonds.
TSP doesn’t make alternative investment choices for its plan holders, but I still think “alts” are good for retirement planners to hold. My suggestions?
Alternative Asset Exposure — PowerShares Global Listed Private Equity Portfolio (PSP): PSP is a group of 65 holdings invested in private equity and business development companies. The total expense ratio is 2.19%, which includes 1.49% in acquired fund fees that are paid by some of the private equity and BDCs for investment in other funds. Net that out, and the true expense ratio is 0.70%.
Alternative Asset Exposure #2 — iShares Cohen & Steers REIT ETF (ICF): ICF invests in 30 of the largest real estate investment trusts in the U.S. including Simon Property Group (SPG), the largest mall owner in the entire world. Although there’s some real estate in the three equity ETFs, I think this fund makes a good counterbalance to the equity funds. With a 30-day SEC yield of 3.26% and an annualized total return of 10% over the past 12 years, it can add a little spice to an otherwise bland portfolio.
As discussed earlier, the portfolio’s asset allocation is 40% equity, 40% fixed-income and 20% alternative assets and cash. For illustrative purposes, I’m going to eliminate cash.
Here, then, is my model $100,000 portfolio:
- Equity (40%): $10,000 VOO, $10,000 DBEF, $20,000 VXF
- Fixed Income (40%): $30,000 AGG, $10,000 BIL
- Alternative (20%): $15,000 ICF, $5,000 PSP
I hope this serves you well. And I will keep track of this retirement “plan’s” performance in the months ahead.
As of this writing, Will Ashworth did not hold a position in any of the aforementioned securities.