This aggressively positioned portfolio illustrates how this increasingly popular strategy works.
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By Christine Benz | 08-30-12 | 06:00 AM | Email Article

Here's your assignment: Gather up all of your retirement accounts and shape them into a portfolio that will supply you with the income you'll need during your retirement years. Oh, and one other tiny to-do: You'll also need to make sure you never run out of money, even though you don't know exactly how long you'll need it.

Christine Benz is Morningstar's director of personal finance and author of 30-Minute Money Solutions: A Step-by-Step Guide to Managing Your Finances and the Morningstar Guide to Mutual Funds: 5-Star Strategies for Success. Follow Christine on Twitter: @christine_benz.

In the past, one simple and elegant solution to the above problem was to buy an immediate annuity that would pay you a stream of income for the rest of your life. But many investors don't like the loss of control that accompanies annuities. A more temporal problem is that today's ultralow interest rates mean that payouts from annuities are lousy right now, as I explored in this article.

One other intuitively appealing idea is to sink your portfolio into income-producing investments such as bonds and dividend-paying stocks and live off whatever yield they generate. That way you might never have to tap your principal at all. The big drawback, however, is that you're buffeted around by whatever the interest-rate gods serve up. When yields are up, you're living high off the hog; when they're miserly, as they have been for the better part of a decade, you have the unappetizing choice of scaling your spending way back or venturing into riskier income-producing securities to get the yield you need.

Given that each of those approaches has become more challenging in the current low-interest-rate environment, it's no wonder that so many retirees and pre-retirees have been receptive to another strategy: "bucketing" their portfolio for retirement. At its core, bucketing is a total-return approach in which you segment your portfolio based on when you expect to need your money. Money for near-term income needs is parked in cash and short-term bonds, while money needed for longer-range income needs remains in bonds and stocks. Financial-planning guru Harold Evensky was a pioneer of the bucket approach; he discusses the basics of the strategy in this video.

Aiming for the Buckets
Why has bucketing become so popular? First, it bows to reality by acknowledging that all but very wealthy investors will need to tap their principal during retirement; it provides a sensible and easy-to-use framework for doing so. And given that many retirees will live for 25 or more years in retirement, the bucket approach provides a necessary dose of long-term growth potential, enabling a retiree to hold stocks as well as safer securities for nearer-term income needs.

Another big advantage of bucketing is that it's flexible. It can incorporate many of a retiree or pre-retiree's existing holdings, and a bucket plan can be readily customized to suit a retiree's own specifications. For example, an older retiree with an expected 10-year time horizon might have just two buckets--one for very short-term needs and another bucket earmarked for the medium term. A younger retiree with a longer time horizon, meanwhile, might have similarly positioned short- and intermediate-term buckets as well as a sizable equity bucket for long-term growth. The unifying theme among all bucket strategies is that the retiree sets aside a pool of cash for near-term income needs, thereby enabling him or her to ride out any volatility that accompanies the mid- and long-term assets.

To help illustrate what an actual bucketed portfolio might look like, let's assume we're building a portfolio for a soon-to-retire couple with the following attributes:

  • They have a $1.5 million portfolio.
  • Their time horizon is 25 years, and they have a very high risk capacity.
  • They plan to withdraw 4% of their initial balance in year 1 of retirement ($60,000), then inflation-adjust that amount every year.

Given those variables, here's a sample bucketed portfolio employing some of Morningstar analysts' favorite funds. (Note that because this portfolio is geared toward risk-tolerant investors with a very long time horizon, it's quite equity-heavy, with a roughly 50% stock/50% bond asset allocation. This profile will be too aggressive for many retirees.)

Bucket 1: Years 1-2

  • $60,000: Cash (certificates of deposit, money market accounts, and so on)
  • $60,000:  PIMCO Enhanced Short Maturity Strategy

This portion of the portfolio is designed to cover living expenses in years 1 and 2 of retirement. Its goal is stability of principal with modest income production. Risk-averse investors who want an explicit guarantee of principal stability will want to stick with FDIC-insured products for this sleeve of the portfolio. On the flip side, investors comfortable with slight fluctuations in their principal values may steer less than a year's worth of living expenses to true cash instruments.

Bucket 2: Years 3-10

  • $130,0000:  T. Rowe Price Short-Term Bond
  • $150,000:  Harbor Bond
  • $100,000:  Harbor Real Return
  • $100,000:  Vanguard Wellesley Income

This portion of the portfolio is next in line to supply living expenses once bucket 1 has been depleted. (Ideally, you wouldn't wait until bucket 1 is empty to replenish it, as discussed in this article.) The goal for bucket 2 is stability and inflation protection as well as income and a modest amount of capital growth. It's anchored by two sturdy, flexible core bond funds--one short-term and the other intermediate. In addition, it includes exposure to inflation-protected securities and a hybrid stock/bond fund (Vanguard Wellesley Income) to provide income with a shot of equity exposure.

Bucket 3: Years 11-25

Because this component of the portfolio will remain untouched for the next decade, the assets here are primarily invested in equities, with smaller stakes in high-risk bonds (Loomis Sayles Bond) and commodities for inflation protection. This is the growth engine of the portfolio, but note that the core equity holding--Vanguard Dividend Growth--focuses on high-quality names and tends to offer better downside protection than many large-cap equity funds. This portion of the portfolio also includes a fairly high stake in foreign stocks, which have the potential to add to the portfolio's volatility level in part because of currency fluctuations. Risk-conscious investors might therefore consider scaling back the foreign-stock portion of the portfolio. (This article provides some baselines for setting your foreign-stock allocation in retirement.)

See More Articles by Christine Benz

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Morningstar - 2012/08/30 - A Sample Retirement Portfolio Using the Bucket Approach - <a href="http://www.morningstar.com/articles/author/30-christine-benz.aspx">Christine Benz</a>
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