We revisit our original bucket portfolio, check up on performance, and make a few tweaks.
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By Christine Benz | 02-13-14 | 06:00 AM | Email Article

"I've been following the bucket strategy with interest. But do you still recommend the bucket portfolios you put out a few years ago?"

I've been receiving a version of this email with increasing frequency during the past several months, and the question is a logical one. I first rolled out the model bucket portfolios--one series using traditional mutual funds and another using exchange-traded funds--in 2012. And it's wise to question any investing information that's more than a year old, especially if it includes specific recommendations. 

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.

The short answer is that yes, the portfolios--both mutual fund and ETF--still make sense to me, and they should, as they're designed for hands-off investors. That said, I'd recommend a couple of small tweaks to the portfolios I initially presented, particularly to remove some interest-rate sensitivity. 

This week, I'll revisit the first of the portfolios--a three-bucket mutual fund portfolio for retirees with time horizons of 25 years or so. With a roughly 50% equity position and the remainder in cash and bonds, the portfolio is aggressive, geared toward younger retirees who are comfortable with the higher volatility that accompanies an equity-heavy mix.

Bucket Basics
The central idea of the bucket strategy, as envisioned by financial-planning guru Harold Evensky, is to include a cash bucket to cover near-term cash needs. Over time, the cash bucket will weigh on the portfolio's performance, as longer-term assets (stocks and bonds) will tend to generate better returns. The big benefit of the cash cushion, however, is that it provides peace of mind for a retiree to know that assets for pending expenses are safely segregated from the more volatile assets in the portfolio. Even in a scenario in which the stock portion of the portfolio dropped precipitously, the retiree could spend the cash in bucket 1 and even move into the portfolio's next-line reserves--short-term bonds--without having to sell any stocks at a low ebb. (For a look at how such a portfolio would function while one is actively drawing from it for living expenses, see my bucket portfolio stress tests.)

This particular portfolio is geared toward retirees who expect to live 25 or more years in retirement. I've assumed a $1.5 million portfolio for illustration purposes, but people with smaller or larger portfolios can scale their investment weightings up or down accordingly. Note that the key step before embarking on any portfolio plan is to ensure that your spending rate is sustainable, as discussed here. I'm assuming a 4% withdrawal ($60,000) in year 1 of retirement, with that dollar amount adjusted upward to keep pace with inflation in subsequent years. As bucket 1 is depleted to meet living expenses, the retiree would refill it using income and dividend distributions and/or rebalancing proceeds.

It's also worth noting that the goal of these portfolios isn't to generate the best returns of any retirement portfolio on record, but rather to help retirees and pre-retirees visualize what a long-term, strategic total-return portfolio would look like. Thus, a newly retired investor could follow the basic bucket concept without completely upending existing favorite holdings. 

The portfolio includes three buckets geared toward the near, intermediate, and long term. I made one change apiece in buckets 1 and 2 compared with my previous suggestions, and I left bucket 3 alone.

Bucket 1: Years 1-2

Original Portfolio

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

Adjustment: Keep entire $120,000 in cash (certificates of deposit, money market accounts, and so on) instead of investing $60,000 in PIMCO Enhanced Short Maturity

The goal of this portion of the portfolio is to provide money for cash needs in years 1 and 2 of retirement. Bucket 1 in the original version of this portfolio included both true cash as well as a small stake in PIMCO's ultrashort bond ETF--for years 1 and 2 of retirement-income needs, respectively. That's not an unreasonable setup, especially for investors who can tolerate a bit of principal volatility that will accompany the ultrashort fund.

That said, investors are not getting paid to take on extra risk in an ultrashort bond fund right now. The PIMCO fund's 0.50% SEC yield can be easily outstripped by a two- or even one-year CD, and its 0.35% expense ratio, while not high, isn't helping matters. As Morningstar ETFInvestor editor Sam Lee said in  his most recent analysis of the fund, investors are better off sticking with cash. I'm with Sam on this one. 

Bucket 2: Years 3-10

Original Portfolio

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

Adjustment: Use Vanguard Short-Term Inflation-Protected Securities Index (or , the ETF) instead of Harbor Real Return; other positions stay the same.

This portion of the portfolio is designed to deliver slightly more income than bucket 1, as well as a dash of inflation protection and capital appreciation. The T. Rowe Price Short-Term Bond fund is there if, in a worst-case scenario, bucket 1 were depleted and rebalancing proceeds and/or income from the portfolio were insufficient to meet living expenses.

Despite the prospective headwinds of rising interest rates, I'm still comfortable with the fact that this portion of the portfolio is anchored in bonds. The linchpin bond holding, Harbor Bond, may suffer some short-term volatility if and when rates rise again; indeed, it lost 3% when bond yields spiked during the summer of 2013. Over time, however, the fund should be able to make up short-term principal losses by swapping into higher-yielding bonds as they become available; manager Bill Gross also has the ability to delve into some bond market sectors that some peer funds can't or won't touch, including emerging markets, and I think that flexibility should hold the fund in good stead.

That said, the portfolio's inflation-protected bond fund, Harbor Real Return, like other long-term Treasury Inflation-Protected Securities funds, carries a formidable level of interest-rate sensitivity. It dropped more than 7% when yields jumped up during the second quarter and another 2% in the fourth quarter. I'm compelled by Vanguard's research that that level of interest-rate sensitivity obscures the inflation protection that such instruments are supposed to bring to the portfolio. Thus, I'm swapping in Vanguard's relatively new short-duration inflation-protected index fund in place of the longer-duration Harbor Fund. (Duration is a measure of interest-rate sensitivity.) The short-term Vanguard fund delivers the desired inflation protection without the extreme rate sensitivity that accompanies longer-duration TIPS.

Bucket 3: Years 11 and Beyond

Original Portfolio

Adjustments: None

The long-term, stock-heavy piece of the portfolio remains unchanged. Due to an anchor position in Vanguard Dividend Growth, the portfolio has a high-quality tilt that's appropriate for a retirement portfolio. That fund's newly arrived investors may be feeling somewhat dismayed that recent performance has been undistinguished, but manager Don Kilbride's strategy tends to earn its keep over a full market cycle rather than during bull markets. A smaller position in Vanguard Total Stock Market supplies exposure to sectors that tend to be underweight in the Vanguard fund. I'm also comfortable with Harbor International despite the impending retirement of one of its comanagers, as the remaining three managers are experienced and have been steeped in the firm's disciplined, value-oriented approach. 

And even though I've previously voiced concern about investors' stampede into higher-yielding bond market sectors, I'm not inclined to reduce the position in Loomis Sayles Bond at this point. For one thing, we're holding the fund with at least a 10-year time horizon in mind. Moreover, I like the fact that the fund isn't wedded to a single risky sector; its managers can venture into foreign-currency-denominated bonds, convertibles, high-yield bonds, and even stocks.

Performance
Due to strong equity market performance, the portfolio has generated strong absolute returns since its launch, gaining approximately 15% since it first appeared in August 2012. (That figure includes reinvested dividends, income, and capital gains distributions and does not include any portfolio withdrawals.) The portfolio has also performed a touch better than a custom benchmark of basic index funds mirroring its asset allocation; that custom benchmark has gained 14.8% during that same time frame. 

Loomis Sayles Bond's return boosted the fixed-income portion of the portfolio, offsetting losses in Harbor Real Return. Harbor International also outperformed a broad foreign-stock index fund during this (admittedly arbitrary) time frame. However, it bears repeating that the idea isn't to shoot out the lights with performance but rather to illustrate the merits of building a well-diversified total-return portfolio for retirement.

Hear more retirement insights from Christine Benz during the Morningstar Individual Investor Conference. Saturday, March 22. Register Now.

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Morningstar - 2014/02/13 - An Aggressive Retirement Portfolio in 3 Buckets - <a href="http://www.morningstar.com/articles/author/30-christine-benz.aspx">Christine Benz</a>
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