A Bucketed ETF Portfolio for Moderate Retirees
Morningstar's Christine Benz creates a hands-off portfolio for retirees with a 20-year time horizon.
With the proliferation of risky and obscure exchange-traded funds, many retirees may well dismiss them out of hand. ETFs are for fast traders who want to speculate on the price of palladium or Gulf currency revaluation, right?
In reality, ETFs have several characteristics that make them a good fit for retirees. Given that the returns from a portfolio diminish as one puts more into bonds and cash instruments, the fact that broad-market ETFs often have very low costs--and will therefore take but a small bite out of returns--should be appealing. The advent of commission-free ETF trades on many platforms is another plus for cost-conscious retirees, as is the fact that ETFs have some structural advantages over traditional mutual funds on a tax-efficiency basis. (The tax treatment of income from ETFs--whether bond or dividend income--is the same as it is for conventional mutual funds, however.)
But perhaps the most important reason retirees might look at ETFs (or traditional index funds, for that matter) is the ability to be hands-off and focus their time and effort on other endeavors. With just a handful of broadly diversified investments, it's easy to assemble a basket of holdings that precisely mirrors your target asset allocation and to rebalance when it gets out of whack.
One my sample portfolios is composed entirely of ETFs and geared toward aggressive retirees with 25-year time horizons and a high risk tolerance; this portfolio features a roughly 50% stock/50% bond portfolio. But not all retirees are comfortable with the fluctuations in principal that will accompany such a stock-heavy mix; they might have shorter time horizons and therefore less time to recover from equity market downturns.
Below I'll provide a sample portfolio for a slightly more conservative retiree--one with a 20-year time horizon. Its allocation is roughly 50% bonds and "other," 10% cash, and 40% stock.
The bucketing concept might sound like a gimmick, but it's really just a way to segment and asset allocate your portfolio based on when you expect to need the money to cover your living expenses. Bucket strategies may differ in terms of the number of buckets and what type of assets go into each. But my bucketing construct employs three: The first bucket is there to cover near-term living expenses; the second is for the middle part of your retirement years; and the final bucket, which is the growth engine of the portfolio, is equity-heavy. Assets are periodically moved from buckets 2 and 3 into bucket 1 to help meet income needs.
A bucket strategy enables you to back into an appropriate asset allocation given your income needs, and it also might help you mentally endure the fluctuations that invariably accompany volatile asset classes such as stocks and commodities. If you know you have enough money in cash to tide you through a rough market, you can put up with periodic downdrafts.
Additionally, the total-return strategy embedded in a bucket approach is appealing in the current low-yield environment. To be sure, the portfolio includes plenty of income-producing stocks and bonds. But if the portfolio's income level falls short of the retiree's target for living expenses, he or she can look to rebalancing and tax-loss proceeds, capital gains distributions, and required minimum distributions to refill bucket 1. The advantage is that the total-return approach lets a retiree build a better-diversified portfolio--that is, one that should have more attractive long-term risk/reward characteristics--than one anchored exclusively in high-income stocks and bonds. This article provides an overview of the bucket strategy.
As with the aggressively positioned ETF portfolio, I used a hypothetical retirement situation to construct the moderate bucket portfolio. In particular, I assumed:
At first blush, that 5% withdrawal rate would seem to be overly aggressive, given that it's higher than 4%, which is generally deemed to be a safe withdrawal rate. But the research supporting the 4% rule employed a 30-year time horizon. Recent research, such as that by my colleague David Blanchett, suggests that retirees with shorter time horizons than that might safely nudge their withdrawal rates higher.
It's also worth noting that bucketing a retirement portfolio allows for a lot of flexibility. For example, though I've provided specific dollar amounts below, they can be readily adjusted to suit smaller or larger portfolios. (I've also provided percentage amounts alongside the dollar values.) Moreover, the portfolios don't require you to start from scratch by scrapping your existing holdings. For example, those with traditional index funds or similar index funds from different providers can readily employ their own funds in place of the ones I've discussed below; an investor could also combine actively managed funds with ETFs and index funds.
Bucket 1: Years 1-2
The liquidity component of the portfolio is designed to meet the couple's income needs for years 1 and 2 of their retirement, so its goal is principal stability. Therefore, it includes true cash instruments. Investors who are comfortable with modest fluctuations in their principal values might consider augmenting one year's worth of cash with a slightly higher-yielding cash alternative such as PIMCO Enhanced Short Maturity (MINT). But with yield differentials between cash and noncash alternatives as low as they are right now, it's hard to justify the risk.
Bucket 2: Years 3-12
This portion of the portfolio steps out on the risk spectrum relative to bucket 1: Its focus is income, stability, and inflation protection, as well as a modest amount of capital growth. The portfolio includes a high-quality short-term bond fund to tap once bucket 1 is depleted--in this case Vanguard Short-Term Bond ETF. It also includes a relatively small slice of a bank-loan fund to help provide some protection against rising interest rates. PowerShares Senior Loan Portfolio is the first and, to date, the only, floating-rate ETF; investors more comfortable with active management in this space should consider swapping in Fidelity Floating Rate High Income (FFRHX) in its place.
PIMCO Total Return ETF is the portfolio's core fixed-income holding. Although it could be vulnerable in a rising-rate environment, the PIMCO team's flexibility to shorten duration and venture into various bond market sectors is attractive. For inflation protection, iShares Barclays TIPS Bond provides inexpensive exposure to Treasury Inflation-Protected Securities, though it will probably also be the most interest-rate-sensitive component of the portfolio. Bucket 2 also includes a fairly small component of high-quality equity exposure via Vanguard Dividend Appreciation. As with the actively managed Vanguard Dividend Growth (VDIGX), its yield isn't high in absolute terms, but it provides exposure to high-quality companies that have demonstrated a good history of increasing dividends.
Bucket 3: Years 13-20
The growth engine of the portfolio, bucket 3 focuses largely on stocks but also includes a dash of aggressive fixed-income exposure. Vanguard Dividend Growth, Total Stock Market, and FTSE All-World ex-US provide core equity exposure with a retiree-appropriate emphasis on high-quality, large-cap companies. To lend additional inflation protection beyond the portfolio's TIPS exposure in bucket 2, I've included a small stake in our analysts' favorite commodity ETF, PowerShares DB Commodity Index.
In lieu of the Loomis Sayles Bond (LSBRX) position included in the moderate bucketed portfolio composed of traditional mutual funds, I've used two niche bond ETFs here: one focused on junk bonds and the other on emerging-markets debt denominated in local currencies. Active management is arguably a better bet than indexing the junk-bond space, as Morningstar's Sam Lee discusses in this article. Although some of the better active junk-bond funds, such as Vanguard High-Yield Corporate and T. Rowe Price High-Yield, are closed to new investors, Fidelity High Income (SPHIX) is a Gold-rated, and still-open, actively managed pick for investors who are willing to include active funds among their ETF holdings.
A version of this article appeared Nov. 1, 2012.
Christine Benz does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.