Whither the Bucket Portfolios in a Low-Yield World?

“Do low yields change how you think about the bucket portfolios?”

I've received variations on that question for the past several months now, as bond and cash yields have dropped through the floor. And it's a good question: My bucket portfolios contain roughly 10 years' worth of living expenses in cash and high-quality bonds. But as readers point out, there's a big opportunity cost to holding so much of a portfolio in low-returning assets.

The short answer is that I don’t think the bucket portfolios need a major--or any--reworking in light of low yields. After all, bucket 1 (cash) and bucket 2 (bonds) were never intended to be a major return engine for the bucket portfolios. That’s the job of bucket 3, which contains mainly stocks. Buckets 1 and 2 are designed to serve as ballast for the equity holdings. If a retiree encounters a terrible equity market and equities stay in a trough for a good long while, he or she could “spend through” buckets 1 and 2, leaving the equity bucket untouched and improving its long-run sustainability. Such a sustained down period isn't idle chatter: The U.S.market basically flatlined during the "lost decade" between 2000 and 2010. Retirees who would have had to draw from their equity portfolios during this period would have left less in place to recover when the market finally did. Buckets 1 and 2 are meant to protect against that possibility, because market history suggests that these asset classes will do a decent job of holding their ground in a sustained equity downturn.

That said, retirees who are concerned about relegating a not-insignificant share of their portfolios to very low-returning assets might reasonably make some adjustments to account for low starting yields, as follows.

A Lower Allocation to Cash and Bonds Wait--didn't I just say that low bond yields shouldn't change the basic structure of the bucket portfolios? I did. But remember that a retiree uses her anticipated withdrawals to determine how she sets up her buckets, specifically how much she allocates to buckets 1 and 2. And if that retiree is concerned about her portfolio's return potential owing to low bond yields, high equity valuations, or both, then the best way to combat that problem is by lowering the starting withdrawal rate.

To use a simple example, let’s say a retiree had been planning to use the 4% withdrawal guideline for his $1 million portfolio. Under that setup, he’d allocate two years’ worth of those expected withdrawals ($80,000) to bucket 1. He’d then steer another eight years’ worth of $40,000 withdrawals ($320,000) to bucket 2. That’s $400,000 in total, or 40% of his portfolio, to those two buckets.

But let’s assume that same retiree plans to play it safer instead, withdrawing just 3% ($30,000) per year in retirement. Under that structure, the portfolio’s allocation to safe, low-returning assets shrinks to just $300,000 or 30% of the portfolio: $60,000 in cash (bucket 1) and $240,000 in bonds (bucket 2).

That safer withdrawal strategy and structure helps protect the portfolio in a few ways: by lowering the withdrawal rate as well as by reducing the amount of assets stashed in low-returning assets.

A Greater Role for 'Buffer' Assets Another way to address a portfolio's allocation to low-returning assets--especially cash, where real yields may well be negative--is to increase its allocation to what retirement researcher Wade Pfau calls "buffer assets" in lieu of cash. In an interview on "The Long View" podcast, Pfau described buffer assets as follows: "[B]uffer assets are assets held outside the portfolio that are not correlated with the portfolio and that can provide a temporary resource to spend from after market downturns to avoid selling portfolio assets at a loss and just try to give the portfolio an opportunity to recover so that you can then subsequently start taking distributions from the portfolio again."

On the short list of Pfau’s buffer assets would be life insurance cash values (to the extent the retiree has some type of permanent life insurance coverage) as well as Home Equity Conversion Mortgages or reverse mortgages. Pfau calls cash “the original buffer asset” but deems it suboptimal because of its very low return potential.

Of course, pulling cash from a reverse mortgage or even life insurance cash value isn’t as straightforward as writing a check from a money market account. Moreover, there are costs associated with both reverse mortgages and life insurance. Carrying life insurance into retirement is also debatable, especially for retirees who have assets and no longer have dependents, such as young children.

Dividend Yielders as a Component of the Equity Portfolio Finally, low yields on cash and bonds mean that income-centric retirees using a bucket structure might reasonably hold a higher allocation to dividend-paying stocks as part of their equity portfolio than might normally be the case. While I still maintain that most retirees should bring a total return mindset into retirement rather than anchoring on current income, it's natural that retirees might want to bring a component of their cash flow needs in through organically generated yield. But even as cash and bond yields have dropped into the 0%-2% range, dividend-paying companies have done a better job of maintaining their payouts.

For example, even as the 10-year Treasury yield has dropped to 0.8% from 1.8% so far this year, the yield on the S&P 500 has held relatively steady: It was 1.8% in January and is 1.75% today. Retirees can capture an even higher payout by steering a portion of their equity portfolio to a good-quality dividend-focused fund. My basic bucket portfolios for retirement use Vanguard Dividend AppreciationETF VIG as their linchpin equity holding, but a good-quality dividend yield-focused fund could work just fine here as well. Vanguard High Dividend Yield ETF VYM, which has a Morningstar Analyst Rating of Gold and focuses on the higher-yielding half of the dividend-paying universe, has maintained a fairly steady dividend yield of 3.6% over the past year, double that of the S&P 500. Its counterpart on the foreign-stock side, Vanguard International High Dividend Yield ETF VYMI, has a slightly higher 12-month yield of 3.8%.

Going this route isn’t without trade-offs, though. For starters, companies with above-average dividend yields often cluster in traditional value sectors. For example, the FTSE High Dividend Yield Index that VYM tracks has a higher weighting in financials and energy than the S&P 500, and much less in the technology sector. That can have meaningful implications for performance at times: Over the past three years, for example, the S&P 500 has returned more than 11% on an annualized basis versus just 3% for the FTSE High Dividend Yield Index. That performance differential owes largely to the latter index’s value leanings.