Welcome to the New Morningstar.comSee what's new
Investing Specialists

A Moderate Retirement Portfolio in 3 Buckets

Christine Benz

Note: The following is part of Morningstar's 2018 Portfolio Tuneup week. A version of this article appeared on Dec. 13, 2017.

The going has gotten tough for retiree finances during the past decade and a half, with extreme stock market volatility, incredible shrinking bond yields, and pensions under fire. Whereas the previous generation of retirees may have been able to easily generate a livable income with a combination of bond and dividend payments, doing so today is a heavier lift. The S&P 500 currently yields about 2%, and high-quality intermediate-term bonds pay a bit more than 2.5%. That means income-minded retirees need to either have a lot of wealth, such that today's low income payout on a 60% stock/40% bond portfolio is enough to live on, or venture into higher-risk parts of the stock and bond markets to amp up their income streams. 

That challenging environment probably explains why the Bucket concept for retirement-portfolio planning has gained so much traction during the past several years. Pioneered by financial-planning guru Harold Evensky, the Bucket approach is simply a total-return portfolio combined with a cash component to meet near-term living expenses. The long-term portion of the portfolio includes income-producing securities, but its main goal is to maximize long-term total return. Proceeds from the long-term portfolio--whether from income, rebalancing, or both--are periodically plowed into Bucket 1 to meet living expenses.

Everything in Moderation
Whereas the Aggressive Bucket Portfolio is geared toward retirees with a 25-year (or longer) time horizon and an ability to withstand the volatility that comes along with a 50% equity weighting, the moderate portfolio assumes a 20-year time horizon and less of an appetite for short-term volatility. It holds a roughly 40% equity stake, with the remainder of the portfolio in bonds and cash.

Even though this portfolio's stock weighting is lower than the aggressive portfolio's, it's not risk-free. With a heavy allocation to bonds, it could suffer losses in a period of rising interest rates. Just as declining bond yields have helped bonds generate strong returns for nearly 30 years, a rising interest-rate environment is likely to result in meager returns from the asset class in the coming decade, or decades. 

That said, I'd point out that the main goal of this and all of the Bucket portfolios is to help the retiree generate adequate cash flow using a diversified total-return portfolio while also preserving principal; capital appreciation above and beyond what's needed for the retiree's living expenses during his lifetime is secondary. Retirees for whom increasing principal is a key aim may well want to run with a higher equity weighting, and the various Buckets in these portfolios can be adjusted higher or lower to suit a retiree's own goals and risk preferences. (This article can help a retiree using the Bucket system "back into" an appropriate asset allocation given anticipated cash-flow needs.) Additionally, even though the portfolios include funds that have Morningstar Analyst Ratings of Bronze or better, investors should feel free to employ their own favorite like-minded holdings in lieu of the ones featured here. 

Moreover, I've taken steps to ensure that the portfolio won't experience undue volatility if and when interest rates trend up. The fixed-income portion of the portfolio emphasizes shorter-duration and more credit-sensitive bonds, and the core intermediate-term fund has a good deal of flexibility to range across bond-market sectors and maintain an active duration stance. (Duration is a measure of interest-rate sensitivity.) 

I've included three Buckets for the Moderate portfolio--geared toward the near, intermediate, and long term.

Bucket 1: Years 1-2

  • 10%: Cash (certificates of deposit, money market funds, and so on)

The goal of this portion of the portfolio is to lock down money needed for near-term living expenses; income production is secondary. Therefore, it holds true cash instruments rather than venturing into investments such as ultrashort funds, which may at times deliver higher yields but do so at the expense of principal volatility. Rather than arbitrarily holding 10% cash, investors should look to their own portfolio withdrawals to determine how large their cash positions should be. Holding two years' worth of cash-flow needs in cash is a reasonable benchmark.

Bucket 2: Years 3-10

Bucket 2 is designed to deliver a higher level of income than Bucket 1; it also aims to preserve purchasing power with a dash of capital appreciation. The risk level in this portfolio stair-steps gradually upward. The Fidelity Short-Term Bond fund would serve as next-line reserves in case bucket one were to become depleted and rebalancing proceeds and/or portfolio income were insufficient to meet living expenses. I've also included a slice of a floating-rate, or bank-loan, fund. This Fidelity fund, while potentially sensitive to the credit cycle, should hold its ground and even gain in a period of rising interest rates. Harbor Bond, a near-clone of  PIMCO Total Return PTTRX, remains the portfolio's largest bond holding.

Because this portion of the portfolio has a longer time horizon, inflation protection is a concern. Vanguard Short-Term Inflation-Protected Securities delivers inflation protection without a lot of interest-rate-related volatility. Investors could also use individual I Bonds in this slot, too. Note that I gave this position a slight boost, as of late 2017; I've outlined the details behind this decision below.

A position in Vanguard Wellesley Income, which features a roughly 60% bond/40% stock allocation, is the longest-term component of the portfolio, providing both income and a shot of capital appreciation. 

Bucket 3: Years 11 and Beyond

The long-term portion of the portfolio, geared toward growth, generally mirrors Bucket 3 of the aggressive portfolio. It includes a high-quality equity emphasis with its position in Vanguard Dividend Appreciation, but it also features broad-ranging sector exposure owing to the total market U.S. index fund. (The original version of this portfolio featured  Vanguard Dividend Growth (VDIGX) in lieu of Vanguard Dividend Appreciation, but the former closed to new investors in July 2016. Vanguard Dividend Growth is a fine option for those who got in before the closure.) Harbor International features experienced managers who employ a disciplined process, though it recently experienced an analyst rating downgrade, from Gold to Silver, I'm retaining it in these portfolios. I also continue to like Loomis Sayles Bond for the long term. Although I've been concerned about investors' stampede into aggressive, credit-sensitive bond types, Loomis' flexibility to invest in foreign bonds, convertibles, and even stocks is an advantage. Just be sure to hold any such fund among your longest-term assets rather than in Bucket 2. 

One major change, however, is that with Harbor's recent announcement to liquidate its Commodity Real Return Fund HACMX, I decided to not replace it with another commodities option. 

The fund has performed poorly, to be sure, but that wasn't the main factor in my decision. (If anything, its poor performance made me tempted to hang on, as poor-performing categories inevitably have their day.) Rather, I found a dearth of decent, low-cost alternatives available to no-load commodities investors. Two commodity funds,  PIMCO Commodity Real Return (PCRIX) and  PIMCO CommoditiesPLUS Strategy (PCLIX), earn Medalist ratings currently. But while the institutional share classes charge a not unreasonable 0.74% per year, neither fund is accessible at a reasonable price without a load through fund supermarkets. (The D shares that are available levy a 1.19% expense ratio, setting up a high hurdle.)

My decision was also influenced by Morningstar Investment Management's 2016 move to reduce commodities in Morningstar's Lifetime Allocation Indexes; I look to those indexes to help determine the portfolios' allocations. In this video, senior portfolio manager Brian Huckstep noted that a phenomenon called negative roll yield has been a significant headwind for commodities futures funds. The indexes didn't cut commodities altogether--most hold roughly 2% positions. But my goal for these portfolios is to limit complexity, and maintaining a 2% position in a niche asset class doesn't jibe with that goal. I steered the 5% of assets that had previously been earmarked for commodities into Vanguard Short-Term Inflation-Protected Securities. That brings the portfolio's weightings in inflation-protected bonds more closely in line with the indexes' TIPS weightings. Moreover, one of the original goals of the commodities exposure was to provide inflation protection, and TIPS fulfill that role, too.

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