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A Sample ETF Retirement Portfolio in 3 Buckets

Morningstar's Christine Benz puts together a diversified basket of investments for those seeking a low-cost, truly hands-off retirement portfolio.

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Note: This article originally posted on Sept. 6, 2012, but we are re-featuring it as part of Morningstar.com's Retirement Readiness Week.

Last week's column featuring a sample portfolio for retirees using the "bucket system"elicited many terrific comments. Some readers characterized the bucket approach as old wine in a new bottle, and I'd agree that there's an element of truth to that assertion. After all, most bucketed portfolios will include cash, bond, and stock components--not a radical departure from the types of portfolios many retirees have maintained all along.

Yet other readers noted that they find the bucket system a useful construct as they think about crafting their in-retirement portfolios. Because the bucket approach segments a portfolio based on when a retiree expects to tap his or her assets for living expenses, it helps take the guesswork out of asset allocation. And having safe reserves on hand to meet income needs also allows retirees to ride out the volatility that's inherent in the longer-term, higher-risk/higher-reward portion of the portfolio.

Some readers requested--both in the comments field below the article and via email--a similar portfolio using only exchange-traded funds rather than the traditional mutual funds that populated my first portfolio. ETFs aren't just for fast-trading institutions and individual day-traders; they can also be ideal building blocks for retiree portfolios. For one thing, any broad-based index product, including ETFs, has set-it-and-forget it appeal. The ability to be hands-off is particularly attractive for retirees who have better things to do with their time than monitor manager comings and goings or worry that their fund manager was leaning one way and the market another. Moreover, many (but not all) ETFs and broad-market index funds feature ultralow costs, and that's a particularly desirable retirement-portfolio attribute because your return potential trends down as you shift more and more assets into bonds and cash. Finally, broad-market equity ETFs' tax efficiency is attractive given that many retirees have a healthy share of their assets in taxable accounts. (Bear in mind that fixed-income ETFs will be no more tax-efficient than mutual funds, however.)

Let the Bucketing Begin
There's no such thing as a one-size-fits-all portfolio, so as with last week's version, I've made some assumptions about the retirees for whom my sample ETF portfolio is appropriate. My assumptions include the following:

  • The portfolio is geared toward a married couple with $1.5 million in assets. (It can readily be customized to suit investors with larger or smaller asset pools, however, assuming the initial withdrawal rate is reasonable.)
  • 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.
  • The portfolio assumes the assets are held within a tax-sheltered account, so the aftertax withdrawal amount would be lower than $60,000. Those with large shares of their portfolios within taxable accounts will need to pay greater attention to tax efficiency, especially with the fixed-income portion of the portfolio. Municipal bonds rather than taxable bonds might be appropriate.
  • The retirees will take a strategic approach to their portfolio management (that is, long-term and hands-off) rather than employ a more tactical strategy. They will regularly move assets from buckets 3 to 2 and 2 to 1, a process that will make the overall portfolio more conservative over time.
  • Those who prefer traditional index mutual funds over ETFs can look to Morningstar's  Gold-rated funds to find index-fund analogs for most of the funds mentioned below.

    Bucket 1: Years 1-2

    • $120,000: Certificates of deposit, money market accounts/funds, other cash

    This component of the portfolio is in place to meet near-term income needs; it emphasizes stability above income production and provides limited growth potential. True cash--CDs, money market accounts, and so forth--is in place to meet income needs in years 1 and 2 of retirement. Investors who are comfortable with modest fluctuations in their principal values might consider breaking the assets in bucket 1 into two components--true cash and a slightly higher-yielding alternative like
     PIMCO Enhanced Short Maturity (MINT), which was featured in last week's portfolio.

    Bucket 2: Years 3-10

    • $100,000:  Vanguard Short-Term Bond ETF (BSV)
    • $200,000:  PIMCO Total Return ETF (BOND)
    • $100,000:  iShares Barclays TIPS Bond (TIP)
    • $80,000:  Vanguard Dividend Appreciation (VIG)

    This portion of the portfolio will spill into bucket 1 once the latter has been depleted. (Assets in bucket 3 will also move into bucket 2 over time.) Thus, it steps out slightly on the risk spectrum: Its focus is income production, stability, and inflation protection, with a secondary goal of capital appreciation. The assets in Vanguard Short-Term Bond ETF are first in line to move into bucket 1. I've used the PIMCO Total Return ETF, an actively managed product, to serve as the core intermediate-term fixed-income position, but indexing enthusiasts who are comfortable with a heavy emphasis on government bonds could stick with a total bond market tracker such as  Vanguard Total Bond Market Index ETF (BND). It also includes a stake in a Treasury Inflation-Protected Securities fund for explicit inflation protection. In contrast with the traditional mutual fund bucket portfolio, which included a slice of a conservative-allocation fund,  Vanguard Wellesley Income (VWINX), this one takes a smaller stake in a pure equity fund, Vanguard Dividend Appreciation.

    Bucket 3: Years 11-25

    • $350,000:  Vanguard Dividend Appreciation (VIG)
    • $200,000:  Vanguard Total Stock Market Index (VTI)
    • $200,000:  Vanguard FTSE All-World ex-U.S. ETF (VEU)
    • $50,000:  SPDR Barclays Capital High Yield Bond (JNK)
    • $25,000:  WisdomTree Emerging Markets Local Debt (ELD)
    • $75,000:  Powershares DB Commodity Index Tracking (DBC)

    The growth engine of the portfolio, bucket 3 stakes the lion's share of assets in low-cost, broadly diversified equity index ETFs. It obtains a quality bias with its largest equity position, Vanguard Dividend Appreciation, which focuses on sturdy companies that have good track records of increasing their dividends, but it also includes exposure to broad-market U.S. and foreign-stock index trackers.

    As with last week's portfolio, the ETF bucket portfolio includes some aggressive fixed-income exposure. I think there's good reason to favor active management in the junk-bond space, as Morningstar analyst Samuel Lee outlined in this article, and my strong preference is for investors to obtain exposure to higher-risk bond-market sectors via a free-ranging multisector product such as  Loomis Sayles Bond (LSBRX), featured in last week's sample portfolio. In lieu of that offering, this portfolio obtains higher-risk, potentially higher-reward bond exposure via a position in a junk-bond ETF and a small position in developing-markets debt denominated in local currencies. As with last week's portfolio--and in keeping with Morningstar's Lifetime Allocation Indexes--this portfolio also obtains additional inflation protection via a commodity-tracking ETF.

    See More Articles by Christine Benz

    Christine Benz does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.