Mon, 20 Mar 2017
Retirement Readiness Bootcamp Part 4: Christine Benz lays out how to use the bucket approach to structure your retirement investments.
Christine Benz: Hi, and welcome back. If you're just joining us, I am Christine Benz for Morningstar.com. All day today, we've been talking about retirement readiness. We just spent a few sessions talking about looking at your income needs in retirement, looking at how much of those income needs will be supplied by certain sources of income, and then we looked a little bit at withdrawal rates in the preceding session.
Now we're going to talk about how to structure your portfolio based on your anticipated spending needs from your portfolio. Before I get into this presentation, I'll just note that you can go ahead and download slides, we'll make them available after the presentation. You can also submit questions and there are instructions below on how to do that. My colleague Jeremy Glaser and I will be tackling some of your questions toward the end of this session.
Let's get right into the presentation and talk about what we'll be discussing in the course of this presentation. I'm going to spend some time providing an overview of the bucket approach, what it is, and why I think it's an intuitive way to think about organizing your in-retirement portfolio.
I'll talk about how to employ a bucket approach with your own portfolio. How to use your own spending needs to dictate how much you hold in each of the buckets. I'll share some sample bucket portfolios for retirees with different income needs, different time horizons, different asset allocations. I'll spend some time talking about how to maintain a bucket portfolio on an ongoing basis. Unfortunately, even though the bucket strategy is a nice intuitive way to approach retirement portfolio planning, it doesn't run itself. You do need to do some ongoing maintenance. I will be sharing some do's and don'ts on the front, and finally, I will spend some time toward the end of the presentation talking about my model bucket portfolios on Morningstar.com. I have created several different versions of these bucket portfolios, I'll share some of them with you, I'll share the thought process behind these model portfolios.
Before I get into the bucket approach, let's recap where we are today because you really need to run through this exercise in order to employ a bucket strategy for your own retirement portfolio. So, the first step in the process is to take stock of your total income needs in-retirement, what you think your spending will look like in retirement? Obviously if you're very close to retirement, this is a lot easier to do than is the case if retirement is further off into the future.
The next step in the process is to assess how much of those spending needs will come from nonportfolio sources of income. So here we're talking about Social Security, perhaps pensions for some of you, perhaps annuity income for others of you, perhaps income from part-time work or income from rental properties if you own them. The idea is to take stock of all of those nonportfolio sources of income. You then want to subtract those nonportfolio sources of income from your spending needs and the amount that's left over is the amount that your portfolio will need to supply. So, you need to stress test that number, make sure that it's a sustainable number, and we talked about how to do that in the preceding session.
So, let's take a look at an example. We'll assume that we've got a 65-year-old couple; they've taken a look at their spending needs in retirement and determined that they need about $100,000 in income from all sources. They've determined that about $40,000 of those income needs will come from Social Security and a small pension. So, they're going to need their portfolio to step up and replace $60,000 of their income needs. If they're looking at a sustainable withdrawal rate, they'll want to make sure that their portfolio is at least $1.5 million, that's the amount that they would need to have saved in order to support that $60,000 per year spending rate, that $60,000 is 4% of $1.5 million.
So, if their portfolio is lower, they need to see if they can tweak the variables a little bit, they need to at least think about delaying retirement or potentially reining in their spending, so that their portfolio withdrawal rate is in the sustainable range.
Now let's take a look at how you can use that spending rate to determine how you organize your portfolio, and that's really the basic idea of the bucket approach to retirement portfolio planning. You look at how much you'll need in the near term, how much you'll need further out in retirement and you use that to right-size each of your bucket allocations. So, your near-term spending needs--this is money that you expect to need in the next one to two years, you don't want to jeopardize your near-term spending by investing in anything too risky, you need to keep that money safe. So, in my bucket approach, I have generally used very safe assets for bucket number one. This covers one to two years worth of living expenses.
For bucket two, we're stepping out a little bit on the risk spectrum. This is money that in my bucket structure would cover roughly years three through 10 of retirement because you have a longer time horizon for this portion of the portfolio. You can afford a take a little bit more risk with it. So here we're holding assets with a little bit of risk, but not too much, primarily high-quality bonds.
For your long-term spending needs where you have a time horizon of 10 years or more, you can definitely afford to take more risk with that portion of the portfolio. So, you're investing primarily in stocks, which are volatile in the short term, but pretty reliable in the long term and generally outperform other asset classes over a very long time horizons.
So, that's the basic framework behind the bucket approach. One caveat that I would point out, though, is that the bucket approach, even though it's a nice intuitive way to approach portfolio planning, it can't solve for a too high withdrawal rate or a too small portfolio. You'd need to look to other levers to help address those issues, but the bucket approach is a nice way to back into an appropriate asset allocation framework given your spending horizon, assuming that that spending pattern is sustainable overall.
So, in terms of the virtues of the bucket approach, why I like it so much as a way to position a retirement portfolio, as I mentioned, it can help you back into an appropriate asset allocation. I think a lot of times people look at asset allocation models and they might seem a little bit black boxy or academic. The bucket approach can help you use your own spending needs to dictate how you allocate your assets across cash and bonds and stocks.
It also helps ensure that you don't have to sell any stocks during a trough to meet your living expenses. The idea is that if you have enough assets in cash and in bonds, that should tide you through rough periods for equities, you can hold on to your equities, let them grow, let them recover from those inevitable periods of market weakness. The bucket approach also enables you to take enough risks so that you can grow your portfolio over the long term, but not enough to jeopardize your near-term standard of living.
Another thing I like about the bucket strategy is that it enables you to psychologically endure those inevitable weak periods for stocks. If you know that your near-term and intermediate-term income needs are set aside, you can put up with the downturns that do accompany stocks from time to time.
And another key thing I like about the bucket approach, and one reason that I began to work on this approach in earnest for Morningstar.com readers and viewers, was that it de-tethers you from whatever is going on with income at any given point in time. So, as many of you know, if you are getting close to retirement or already retired, we've seen yields go way, way down, and that has left retirees with the unfortunate choice of having to make do on less and less in income or to venture out on the risk spectrum in search of income.
The bucket strategy enables retirees to not focus so much on income but instead focus on building a total return portfolio with the best possible risk return profile for them and not worry so much about the current income that their portfolios are generating. Before I go any further, I would say that we very much embed income producing securities within the context of these bucket portfolios, but current income generation is not a key goal for these portfolios.
This is just a quick visual depicting the bucket approach in action. You can see that in my bucket portfolios, I've employed generally three buckets--one for near-term living expenses. I've parked one to two years worth of assets of spending needs in bucket number one. We're not taking any risk with this portion of the portfolio. This is primarily cash or entirely cash and here you're talking about CDs, perhaps money market mutual funds or money market accounts. Right now, online savings banks are some of your best sources of guaranteed yield. We're not taking any risks with this portion of the portfolio though.
I sometimes get questions from retirees who say, well what about bank loan funds, or what about real estate investments. You'd want to put them in your later buckets. You don't want to jeopardize your near-term spending by venturing out on the risk spectrum with bucket number one.
Bucket two as you can see, edges a little bit out on the risk spectrum. This is where I've parked assets for years three through 10 of retirement. In my bucket portfolios, I've generally used high quality short- and intermediate-term bonds for this portion of the portfolio. I've also used a little bit of high-quality equity exposure. You might think about using a balanced fund or some sort of conservative allocation fund for this portion of the portfolio. And here I've earmarked the assets for years three through 10 of retirement.
Bucket three is the risk engine of the portfolio. It's the return engine of the portfolio as well, so it holds primarily equities. It holds a globally diversified equity portfolio in my framework. It will cover you for years 11 and beyond of your retirement. So, for new retirees, you can see that if you're using a structure like this from a practical standpoint, it would mean that they would probably have most of their assets in bucket three, if they have a nice long time horizon through retirement.
For older retirees that would mean that they would have more of their assets in buckets one and buckets two, perhaps their bucket three would be a little smaller. So, this is the general framework that I've used when structuring the various bucket portfolios that I've created for Morningstar.com.
A logical question is how I decided which types of assets to put inside each of these buckets. The short answer is that I use the probability of having a positive return within each of these time horizons to determine the asset class that I used. So, for very near-term income needs where we just have a one or two-year time horizon as is the case for bucket one, we can't take any risk with that portion of the portfolio at all. So, I've used true cash instruments, because it's the only asset class where you can find a guaranteed rate of return, granted it's a guaranteed low rate of return right now, but nonetheless it's a guaranteed rate of return.
For bucket two, because we have a time horizon of three years or longer, we can afford to take a little bit more risk with this portion of the portfolio. So, bonds over any rolling three-year period that we look at have been extraordinarily reliable certainly over the past 25 years. So, within bucket two, we do use high-quality bonds because even though they may have periods of short-term losses, they will generally be pretty reliable to hold their value over any three-year period.
Bucket three is where we hold the growth-producing assets. Stocks are way too volatile for bucket two certainly to be the core of bucket two. But once you have a 10-year time horizon or longer, stocks are actually quite reliable. So, when we look at rolling 10-year periods for stocks, what we see is that over various 10-year rolling time horizons that stocks have actually been really reliable. They've had positive returns about 90% of the time. So, if you have a time horizon of 10 years or longer, you should be primarily invested in stocks because of their higher return potential.
So, let's run through some examples of how retirees can use their own situations in their own spending needs to determine how they employ these buckets.
So, this baseline case here is Jack and Carol, they are 65-year-old new retirees, both the same age, and they're using a 4% withdrawal rate with that 3% annual inflation adjustment from their $1.5 million portfolio. So, they're taking a $60,000 annual withdrawal from their portfolio. They will nudge that withdrawal rate up a little bit as the years go by to account for inflation. So, they have a 25-year anticipated time horizon in retirement and they have a fairly aggressive risk tolerance to match.
So, they're willing to hold at least 50% of their portfolio in stocks, and they want to use the bucket approach to positioning their portfolio. In terms of how that would translate into how they position their portfolio, they would hold two years worth of living expenses, so $60,000 times two in bucket one. They are not messing around with this piece of portfolio. They are holding true cash investments with this portion of the portfolio.
With bucket two they are taking a little bit more risk. So, they are earmarking enough cash flow for years three through 10 of retirement so that's $60,000 times eight years, $480,000, and they are staging this portion of the portfolio by risk level. This is kind of how I've thought about structuring my model bucket portfolios. We're starting with very safe securities at the top of the portfolio--so short-term high-quality bonds at the top followed by high-quality intermediate term bonds, followed by a little bit of conservative allocation fund in this case.
So, the idea of that structure of stair-stepping bucket two by risk level is if in some sort of catastrophic scenario and they've spent through their bucket number one, they don't have any more cash left because rebalancing proceeds or income from their portfolio was insufficient to meet their income needs they can then turn to bucket two as next line reserves and they would probably draw from those high quality short-term instruments first.
So, that's the basic structure of bucket two. It takes a little bit more risk but not too much risk relative to bucket one.
Then bucket three this is the growth engine of the portfolio. This is loosely modeled on my model mutual fund bucket portfolios, you can see that the bulk of this portfolio is in high-quality U.S. equity exposure, they do have some high-quality foreign stock exposure. This is where I would also hold some higher risk fixed income types. So, to the extent that you want to hold say junk bonds or emerging market bonds or in the case of my model portfolios some sort of a multi-sector bond fund I would hold it here where I have a nice long time horizon. The reason is that high-yield are riskier, bond types can periodically experience periods of extreme volatility, so you want to make sure you have a nice long time horizon for them.
I've also made room for a little bit of commodities exposure in this portion of the portfolio. This is kind of a controversial subject. The idea is to provide a little bit of extra diversification because commodities are quite volatile as standalone investments, I've kept the position in the portfolio quite small and I have also made sure to have a nice long time horizon for this portion of the portfolio. If you wanted to make room for equity, precious metals funds, or say a real estate fund I would hold it in this portion of the portfolio. The same would be true for any individual equity holdings, I want to make sure that I had at least 10-year time horizon for them, so I would hold them in bucket number three.
You can see that in the case of this hypothetical couple, this is the lion's share of their portfolio. They had $600,000 of their portfolio allocated to buckets one and two, but the bulk of their portfolio is in bucket three, in part because they have such a nice long time horizon in retirement.
My next hypothetical case is Ed. Ed is a bit older than the previous couple. He's 85 years old. He has a $300,000 portfolio. He's spending about $25,000 a year from the portfolio. He anticipates that he has about a 10-year time horizon to be spending from that portfolio, that's his anticipated life expectancy, he wants to use a bucket approach, he likes exchange-traded funds and he has long-term care insurance. Just to simplify this example, we'll assume that he doesn't have a long-term care need, in reality this could be more complicated if he did not have such an insurance policy or even if he did, but we'll just assume that the long-term care need is not part of his retirement portfolio plan.
So, let's take a look at his bucket portfolio. As I mentioned, he has a $25,000 spending need from the portfolio multiplying that by two determines how much he should hold in bucket number one, so he has about $50,000 earmarked in true cash investments. Then his bucket two is the rest of his portfolio because his time horizon is fairly short for his retirement portfolio, he can't afford to take a lot of risk in stocks. He can have a little bit of equity exposure, but with a less than 10-year time horizon, or a roughly 10-year time horizon, he doesn't want to have too much parked in stocks. So, the bulk of his bucket two is high-quality fixed-income exposure, short-term as well as intermediate-term and we've also tacked on a little bit of high-quality equity exposure, the exchange-traded fund that I've used here is Vanguard Dividend Appreciation, the ticker is VIG.
So, Ed's portfolio doesn't include a bucket number three, because he anticipates that his time horizon is roughly 10 years, so he can get it done with just two buckets.
Madeleine is a different story. She is a new retiree, a 60-year-old retiree. This is not a common scenario where she has a lot of her income needs being met from a pension. Unfortunately, it's a smaller and smaller segment of the population that is retiring with a pension, but in Madeline's case we're assuming that she has a pension that's stepping up and providing most of her in retirement income needs. So, she's really just sipping from her portfolio. She's spending just $10,000 annually from her $500,000 portfolio. She anticipates that she will have a roughly 30-year time horizon in retirement. She wants to use the bucket approach and she has a high risk tolerance. She knows that a lot of her income is going to be coming through the door, through her pension. So, she's comfortable taking extra risk with her portfolio.
I'll just stop right there and say that Madeline's high-risk tolerance may not fit everyone. There may be retirees for whom even though stable sources of income are meeting a lot of their income needs they may just not be comfortable with the high volatility that can accompany a mostly equity portfolio, in which case, by all means they'd want to stick more of their portfolios in safe securities. But just for the purpose of illustration we're assuming that Madeline has that high-risk tolerance. She can take more risk. Perhaps she wants to earmark and grow her assets for her heirs or perhaps for charity.
So in Madeline's case, we're assuming that she has that liquidity portfolio and you can see because her spending demands from that portfolio are quite low, she can afford to have just a little bit invested in bucket one. She doesn't have to hold all that much in safe securities. So, she can just take her spending need times two or perhaps she'd want to enlarge it to accommodate emergency expenses or perhaps some trips that she'd like to take in the early years of her retirement. But she doesn't need to stake too much in bucket one because so much of her spending needs are being met through that pension.
Bucket two is also pretty small in Madeline's case, so we're assuming that she has $80,000 in her bucket two. She's holding primarily bonds in this portion of the portfolio or entirely bonds in this portion of the portfolio. Again, high-quality, short- and intermediate-term bonds.
In Madeline's case her bucket three is the bulk of her portfolio. We talked about Ed not having a bucket three. Madeline has a very large bucket three because she has such a long time horizon for the spending for that portion of her portfolio. So, she has her portfolio invested primarily in equities. Her bucket three is invested primarily in equities. She has a high-quality index fund. Vanguard Dividend Appreciation, as well as, Vanguard Total Stock Market Index. She holds a foreign stock fund, as well as, some junkier fixed-income exposure via Loomis Sayles Bond as well as a dash of commodities exposure as was the case in our first illustration.
So, you can see that in Madeline's case, the bulk of her portfolio is staked in bucket three because of her limited spending needs from her portfolio.
So, let's talk about bucket maintenance because as I mentioned at the top, bucket portfolios don't maintain themselves. You need to do a little bit of work to keep them up to date on an ongoing basis.
So, the basic idea if you're using a bucket strategy is that you're going to spend from that bucket number one on an ongoing basis. You're going to use your bucket number one to meet your spending needs. But you periodically need to replenish it and that's where the maintenance piece of this comes in. So, for some retirees, if they have income-producing securities in their portfolio, whether dividend paying stocks or bonds, they can simply use those income distributions and plow them into bucket one on an ongoing basis. They can periodically top off their bucket number one, in fact, they can have those distributions automatically moved into a bucket one.
They might also need additional income above and beyond what their portfolio is supplying organically, though, and so in that case they'd want to turn to rebalancing. So, in 2016 for example, we saw a very strong market for the stock market; a retiree who needed to rebalance to harvest some cash flow from his or her portfolio might have scaled back on stocks to plow money into bucket one. So, the approach that I really favor is kind of a hybrid approach, where you're seeing how far your income distributions can take you in terms of replenishing bucket number one. And then you're periodically scaling back, appreciated portions of your portfolio to meet additional income needs as you have them. I think that that strategy can make a lot of sense for retirees.
What bucket maintenance doesn't mean, is that you're not spending through the buckets sequentially. So, some retirees might assume that when we talk about this three-bucket strategy, it means that you spend through bucket number one, then move on to bucket number two, you spend it all down. Then you move on to bucket number three and spend that. That might seem like an intuitively appealing approach, but the risk that it courts is that you would get to bucket three at a time when your equity portfolio, your bucket three was in a little bit of a trough. So, you don't want to be in that position of having to invade your equity portfolio when it's down. So, that's not an approach to bucket maintenance that I would advise.
Bucket maintenance also doesn't mean that you're constantly moving money from one bucket to the next. So, some retirees might assume that when we talk about this bucket strategy, it means that we are constantly moving money from bucket three to two and two to one and that you're doing this all the time, that's just too much work in retirement. My thought is that you use the income distributions to see how far they'll get you, in terms of replenishing your bucket number one. If you need additional income from your portfolio or additional cash flow from your portfolio, you'll then turn to rebalancing to help top off your bucket one further.
So, let's take a look at how bucket maintenance would work in practice. Let's assume that we have a retiree who needs $40,000 in cash flow from his or her $1 million portfolio and they needed to refill bucket one in 2016. So, they've spent through what was in bucket one. They want to replenish, bucket one they want to top it back up. So, assuming that person had a 60% S&P 500 tracker with a portion of the portfolio and had a 50% bond portfolio. That portfolio would have yielded about $21,000, a little bit more than $21,000 in 2016, so that's not quite there to $40,000. So, the retiree would need to get that additional $18,000, $19,000 from doing some rebalancing in the portfolio.
The good news is that 2016 was a really good year for the equity markets, as I just mentioned. So, that portfolio would have generated a capital return of about $106,000 in 2016. So, of the $40,000 in income needs in retirement about $21,000 of that would have come from the organically generated income return from that stock and bond portfolio. And then the retiree would get the remaining $18,000, $19,000 from capital return from rebalancing the appreciated equity position. The retiree could then reinvest the remaining capital return into depreciated parts of the portfolio. So, assuming a really simple portfolio, you would reinvest in bonds assuming that the portfolio consisted of just a U.S. equity and a fixed-income piece.
In terms of my model bucket portfolios on Morningstar.com, I created a lot of different variations of these bucket portfolios. I wanted to spend a little bit of time talking about what I was trying to achieve, what I've been trying to achieve with these portfolios. They're designed to depict what I think are sound asset allocation and portfolio maintenance practices for in retirement portfolios. They're not designed to blow the doors off of any other retirement portfolio strategy ever designed.
So even though I think that they're sensibly created, sensibly maintained, they're not really gunning for the highest possible return. They're just designed to depict what I think are sound portfolio management and maintenance practices on an ongoing basis.
To help structure the portfolios, I've used Morningstar's Lifetime Allocation Indexes to help structure the portfolios. These are created by a team within Morningstar Investment Management. They are indexes that you can take a look at. They may or may not match your own situation, but I think that they generally depict sound asset allocation principles.
I use a strategic approach to setting the portfolios' asset allocations. That means that I'm not going to try to jockey around to capture the best possible return from any asset class at any given point in time. Generally going to just rebalance back to the target asset allocation on an ongoing basis. I make changes only if the fundamentals of the portfolios change.
So, for example, as long as I've been managing these portfolios, we've had a fund close, Vanguard Dividend Growth, I mentioned closed to new investors. We've replaced it with Vanguard Dividend Appreciation. We also look to the analysts' ratings to help structure the portfolios.
So, initially with my baseline traditional mutual fund bucket portfolio, I used T. Rowe Price Short-Term Bond Fund. It's still a solid fund, but it has been downgraded to a neutral rating. I swapped in the Silver-rated Fidelity Short-Term Bond in its place. So I use the analysts' ratings to help light the way of how to position these portfolios.
I'm assuming in the case of all of these portfolios that if you're using them, that you use your own spending rate to right-size your allocations to each of these asset classes. So, you'd start with your spending needs to structure how much to hold in bucket one, and then you'd structure the other buckets of your portfolio accordingly.
Let's take a closer look at my aggressive mutual fund bucket portfolio. This is the first portfolio that I created for Morningstar.com. You can see that, as we've talked about, it includes the liquidity piece. We are not taking any risk with this portion of the portfolio. Right now, for most investors the best source of, safe yield will be some sort of an online savings account, where you may be able to earn a yield of, say, 1% on your money today. This is a portion of the portfolio that may not out-earn inflation over time, which is why you don't want your bucket one to be too large. You don't want to be thinking about holding anything like five years worth of living expenses in bucket one because you may actually lose money on an inflation-adjusted basis over time. So roughly 8% of this portfolio is allocated to just true cash guaranteed, FDIC guaranteed instruments.
The next portion of the portfolio, bucket two, is primarily high-quality fixed-income exposure. You can see that we've included some high-quality short-term exposure, both Fidelity Short-Term Bond, as well as Vanguard Short-Term Inflation-Protected Securities, which invests in short-term TIPS, bonds. Here I've used Harbor Bond to be kind of the core fixed income piece. Investors who have other core fixed-income holdings could use them in this context. So perhaps you hold Vanguard Total Bond Market or a Fidelity Total Bond or Dodge & Cox Income or MetWest Total Return Bond, any of those core intermediate term bond funds could work well in this context, but here I've used Harbor Bond, which is a no-load, near-clone of PIMCO Total Return.
I've also used a little bit of Vanguard Wellesley Income in this portion of the portfolio. This is a conservative allocation fund that has roughly two thirds of its assets in fixed-income investments and the rest in high-quality income-focused equities.
The bucket three of this portfolio is the growth engine of the portfolio earmarked for years 11 and beyond of retirement. As I've done with all of the other samples that I've shown you, I've allocated the lion's share of this portfolio to high-quality U.S. equities. I have included Vanguard Dividend Appreciation as a high-quality dividend-focused offering. I would take pains to point out that it doesn't have a yield that's high in absolute terms. In fact, its yield is roughly in line with the broad markets, but it is generally a higher-quality basket of stocks than you get with a total market index fund.
I've included Harbor International as my core international piece of this portfolio. Investors will want to think about holding roughly 25% to 30% of their total equity portfolio in some sort of a global or foreign stock equity fund.
I've also included a little bit of lower-quality fixed income exposure. Loomis Sayles Bond has been the fund that I've used here, as well as a little bit of commodities exposure with this portion of the portfolio.
The moderate bucket portfolios, I've created them in both traditional mutual fund, as well as exchange traded fund versions. In the case of the ETF version, which is featured here, you can see that it has a little bit more in cash, but again, a retiree should use his or her own anticipated spending needs to right-size how much to hold in bucket one. Bucket two, again, is high-quality fixed income exposure largely. And you can see that the complexion here of the ETF-only portfolio really mirrors what we had in the case of the traditional mutual fund portfolio.
So, you have high-quality fixed-income exposure. You also have a little bit of high-quality equity exposure at the tail end of this portion of the portfolio. So here I've used Vanguard Dividend Appreciation, in this case the exchange-traded fund versus the traditional mutual fund.
And then the growth piece of this portfolio, it's a little smaller than was the case for the aggressive portfolio, but it still has ample equity exposure. So, we've got sizable positions in Vanguard Dividend Appreciation, as well as Total Stock Market Index. We also have a Total Foreign Stock Market Index Fund that includes some emerging markets, as well as mostly developed markets exposure. We have a little bit of lower-quality fixed-income exposure with this portion of the portfolio. So, a little bit in a junk bond fund, a little bit in a local currency denominated emerging-markets debt fund, and here we are holding fairly small positions because as standalone investments, these are pretty volatile investment types. We've also got a nice long time horizon for them. And finally, we've got a little bit of commodities exposure for this portion of the portfolio as well.
I've also created some tax-efficient bucket portfolios. These are designed for the nonretirement account portion of your portfolio subject to the extent that you have taxable assets, that's what these portfolios are designed to help you structure. And so you can see that in the case of this conservative bucket portfolio, I've used true cash investments for bucket one. You might use some sort of municipal cash investment, but right now yields are so low across the board. And bucket two isn't large enough that it should matter a lot whether you use some sort of muni account or whether you use a taxable account. But you can see that in bucket two I have prioritized municipal bond funds, I've used Fidelity's funds for the bulk of these tax-efficient mutual fund portfolios. And I've used some short-term exposure as well as some intermediate term exposure.
For bucket three of these tax efficient portfolios, I've use tax-managed funds for the U.S. equity piece. You can certainly use some sort of a total U.S. market index as well as a total foreign market index for this piece of the portfolio. In fact, I have used Vanguard FTSE All-World ex-U.S. fund to be the foreign stock piece. But the basic idea of using index funds or tax-managed funds here is that they tend to limit taxable capital gains distributions. So, they tend to be nice tax-efficient holdings for your taxable account. So, that's the basic idea behind these tax-efficient bucket portfolios.
In addition to some of the bucket portfolios that we've just talked about, I have also created bucket portfolios for people who choose to hold their assets with a single mutual fund family. So, I've created bucket portfolios for Vanguard, Fidelity, T. Rowe Price, and Schwab investors. So, if you care to do your business with just one platform, those portfolios can help you figure out what would be some reasonable holdings for your in-retirement bucket portfolios.
I would take pains to say though that you should absolutely, if you have holdings that you really like, that you've lived with for many years that you should absolutely stick with them when structuring your own bucket portfolio. This bucket strategy is not meant as a call to append what you've got. Chances are if you've got a well-diversified balanced portfolio, you already have a lot of the building blocks that you need to create your own bucket portfolio.
Now I'm just going to spend a little bit of time talking about some back tests that we've done on these model bucket portfolios. They've only been around for a few years, but we decided to look back in history to just take a look at well how did this bucket strategy do over some more punishing time horizons. So, I started this simulation of how the bucket strategy would have performed back in 2000 which has been as many of you will remember was a difficult market for equity investors. We had that big sell-off in growth-oriented equities, a big market shock overall. It would have been a tough time to retire.
So, I made some assumptions about how the portfolios were being updated and maintained on an ongoing basis, I've included them here. I assume that the retirees were taking a 4% initial withdrawal and then giving that a little bit of a nudge up to account for inflation in each year. I assume that the retirees were forgoing the inflation adjustment in years when the market was down. And I assumed pure total return approach. So, I assume that the retiree was relying exclusively on rebalancing proceeds to help top up bucket one.
And the results when we looked back on how these portfolios would have behaved were pretty encouraging. So, what we saw was that the bucket portfolios were able to meet that income need that we identified at the outset of the simulation so that was encouraging and the portfolios at least at the end of 2015 were able to hold their ground nicely over that time period as well.
I would note a couple of things though before I get too carried away in terms of touting these returns. So first I would say that this is a pretty favorable time period overall. So even though it was punctuated with some difficult market environments notably a tough market environment in 2000 through 2002 and then of course during the financial crisis what we have here is positive end-date bias. So, after the financial crisis, as you all know, we've experienced a very positive equity market environment, so that arguably makes us look a little smarter than we are.
And another point I would make is that I compared this bucket strategy and the performance of a bucket portfolio versus a portfolio that didn't have that bucket number one that didn't have any dedicated cash investments. And what I would say is that the bucket approach actually underperformed that fully invested portfolio. So, if we took bucket one and invested it in stocks and bonds rather than holding cash aside what we saw was that the bucket approach actually underperformed that fully invested approach. I think what that simulation doesn't capture though is the peace of mind that you get by knowing that you have your near-term income need set aside and that's part of why I think the bucket strategy can be so appealing.
And now Jeremy Glaser is here, we're going to tackle some of your questions which you've already submitted. If you'd like to submit a question even still please use the instructions below to do so. We look forward to tackling some of them.
Jeremy Glaser: Christine, thanks for the presentation. The first question is on if someone wanted to simplify the bucket strategy, you know it's still too many holdings, still too much maintenance--is there a way that you could even make this simpler if that's something that user or an investor would want to do?
Benz: Absolutely, I think that's a really worthy goal, and probably the best way to do that would be simply to think of your cash piece, think of maybe some single high-quality bond fund. I might add short-term as well as an intermediate-term fund, so I might have a two parter there for bonds; high-quality short term, high-quality intermediate term. You could use index products there. And then use total market index funds for both U.S. stocks and foreign stocks. And then I think you could call it a day and that would give you some discretion over where to go for living expenses if you needed to refill that cash piece and of course, you'd want to hold cash too.
So, I like that idea if you want to reduce the number of moving parts in your portfolio, it's hard to go wrong with that low cost, broadly diversified index fund or funds. One question I sometimes get is, how about a single fund? A one fund solution to my de-accumulation problems, and I love single fund solutions for accumulators. I think target-date funds for example are one of the great innovations from the financial services industry ever. But I would say that when it comes to de-accumulation, ideally, I think you would want to reserve the right if you're having to refill this cash bucket on an ongoing basis. It seems like you'd want to reserve the right to decide where you go for that cash on an ongoing basis.
So, end of 2016, for example, I don't want to pull proportionately from stocks and bonds as would be the case if I had some sort of an all-in-one fund. I want to reserve the right to go right to my highly appreciated stocks, leave my bonds alone, maybe even add to my bonds and add to my cash holdings. So, that's I think one potential drawback when it comes to de-accumulation and the single fund solution that you lose a little bit of that discretion over your cash flows.
Glaser: It's possible to simplify then but maybe not too much.
Glaser: We have a question that touches on something that we talked about earlier in the day about asset location. When you think about the buckets, are there different account types, say, Roth IRA, or traditional IRA that you have in mind for each bucket or is it going to depend on an individual situation?
Benz: It depends unfortunately, I guess in a really simplified example, let's say, an investor came into retirement and had his or her cash needs cued up as well as the bond needs and the long-term needs. Ideally, you'd sort of think about, as Maria and I talked about in an earlier session, you think about pulling your more liquid assets or parking your more liquid assets in the taxable accounts. And then perhaps moving on to tax-deferred accounts, so maybe that bucket two to the extent that you have a bucket two, you'd want to have that in your tax-deferred accounts. And then the Roth accounts kind of the growth engine of your portfolio, I guess that's where you'd want to think about having the high growth equity assets.
But many people, as Maria said, are coming into retirement with portfolios that are very tilted toward traditional tax-deferred accounts. So, for them, most of their portfolio would be in that tax-deferred account. So, buckets two and three perhaps would be in that tax-deferred account and maybe you'd keep your liquidity in your taxable portfolio.
Glaser: The question we have here is from a younger retiree who wants to know how you would change the asset allocation, change what's in each bucket if you, say, were in your early 60s and are already retired?
Benz: I think it's really valuable to take a step back and think about your cash flow needs and use that to structure your portfolio. So one to two years worth of living expenses in true cash instruments, then again I would say roughly eight years worth of living expenses, the next eight years worth of living expenses in largely high quality bond portfolio. And for that new retiree, from a practical standpoint, most of their portfolio would go in the equity bucket. So, I think that it is really valuable to use your cash flow needs as a starting point for how you structure each of these buckets.
Glaser: We have a question about inflation and how it could impact the cash part of your cash bucket. If you are worried about inflation is there really anything you can do about that or does cash have to be cash?
Benz: My bias is toward just keeping it in true cash instruments, your bucket number one and the fact of life is, you know, if your bucket one is one to two years worth of living expenses, inflation is not going to completely destroy the purchasing power of your whole portfolio. For buckets two and three, that's where I think you need to think more about inflation protecting those portions of the portfolio. So, in my model portfolios, you saw the TIPS, Treasury Inflation-Protected Securities appeared in bucket two. Bucket three is very tilted toward equity exposure, while equities aren't a direct hedge against inflation. They do have--over time have shown the ability to outearn inflation. So, I think you want to worry less about inflation protecting bucket one, focus more on adding that inflation insulation to buckets two and three.
Glaser: How often should we balance through buckets? Is this something that should be happening on a quarterly basis, annual basis, what would be a good timeline?
Benz: Quarterly sounds like too much maintenance to me. I think in terms of maintenance, the strategy that I really like is setting it up with your financial providers so that your income distributions are funneling right over to that cash account to provide kind of a baseline of your cash flow needs and then once a year get in there and do that rebalancing and see where you can prune your portfolio and top up your cash bucket. But I think doing it much more than once a year, probably is overly complicated. The thing about doing the year-end rebalancing too is that you can kind of keep an eye on tax issues as well, if you kind of focus that rebalancing process toward the end of a given calendar year.
Glaser: Well, Christine, thank you so much for sharing the bucket portfolio.
Benz: Thank you, Jeremy.
Glaser: Stay tuned to next we're going to hear from some Morningstar experts including Russ Kinnel, Ben Johnson, and Sarah Bush. They are going to give some ideas of other investments that you can put in your retirement accounts. Stay tuned, that will start in just five minutes.