A Conservative Retirement Portfolio: The ETF Version

A conservative retiree portfolio featuring exchange-traded funds might seem like a contradiction in terms. But as I noted when I discussed a moderate ETF portfolio, ETFs have some attributes that can make them a good fit for retirees. Provided you stick with low-cost ETFs that track broad market segments, you'll keep your overall portfolio costs low--a laudable benefit given that your portfolio's absolute return level is apt to downshift as you move more assets into cash and bonds. And for retirees who have a decent share of their portfolios in taxable accounts, ETFs have some features that could reduce the drag of taxes on an ongoing basis. (Note that ETFs that kick off bond and dividend income won't be any more tax-efficient than similar traditional mutual funds, however.)

But the biggest benefit of a portfolio anchored in broad-market ETFs or index funds is the ability to be hands-off. With a few small tweaks every once in a while, such a portfolio could virtually run itself for a while if need be. Given that most retirees have better things to do with their time than toil over their portfolios, that's a valuable attribute indeed.

Below I'll feature a shorter-term bucket portfolio, consisting of ETFs, for those more conservative retirees. Its asset allocation is roughly 30% equities, 60% bonds and "other," and 10% cash.

Buckets: What You Need to Know
"Buckets" may seem like gimmickry, but segmenting your portfolio based on time horizon--which is the essence of bucketing--can help you visualize what your retirement portfolio should look like based on when you expect to need the money. Under the framework I've been using, money for near-term income needs gets parked in bucket 1. Bucket 2 houses intermediate-term assets--typically bonds--while bucket 3 is the longest-term portion of the portfolio and consists mainly of equities. The shorter the investor's time horizon, the higher the percentage of total portfolio assets that will be parked in buckets 1 and 2. As bucket 1 is depleted, it gets refilled with assets from buckets 2 and 3.

In contrast with an income-only approach, which can send an investor into riskier and riskier securities if high-quality stocks and bond yields are as low as they are today, the bucket approach uses a total-return framework. That means the investor can be opportunistic about where he or she goes for income. As bucket 1 becomes depleted, investors can replenish it with bond and dividend income, capital gains distributions, rebalancing proceeds, and required minimum distributions. The advantage of this catholic approach relative to an income-only strategy is that the retiree can build a better-diversified portfolio--and therefore one with better risk/reward characteristics--than would be the case with an income-only strategy.

Assumptions
As with the previous portfolios, I used a hypothetical retirement situation to construct the bucket portfolio. In particular, I assumed:

• A married couple with a 15-year time horizon and low to moderate risk tolerance.
• $750,000 in total portfolio assets.
• A 5.5% initial withdrawal rate, meaning that they will withdraw $41,250 of their portfolio in year 1 of retirement, then inflation-adjust that amount in each year thereafter. (Assuming a 3% inflation rate, the year-2 withdrawal would be $42,488.) Income from Social Security and other sources would be on top of the $41,250 distribution.
• The desire to spend all their money during their lifetimes (that is, no desire to leave a legacy).
• They hold all of their assets within a tax-sheltered account, so the aftertax withdrawal amount would be lower than $41,250. 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-bond funds rather than taxable-bond funds 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.

For investors steeped in the 4% rule for sustainable portfolio withdrawals, a 5.5% withdrawal rate would seem to be overly aggressive. But as financial-planning expert Michael Kitces discusses in this video, the 4% rule stress-tested withdrawal rates during a 30-year time horizon. For investors with shorter time horizons, a higher withdrawal rate is reasonable, and in this case could arguably even go higher than 5.5%. Meanwhile, those with retirement horizons of more than 30 years will want to withdraw even less than 4% during year 1 of retirement.

Retirees shouldn't think that they need to reinvent the wheel to adopt a bucket approach. For example, though I've provided specific dollar amounts below, they can be readily adjusted to suit smaller or larger portfolios. (I've supplied percentages to enable you to do so.) Moreover, the portfolios don't require you to start from scratch by scrapping your existing holdings. For those with reasonably well-diversified portfolios consisting of sturdy core positions, those can be readily swapped in instead of the specific funds I've mentioned below. Traditional index funds could supplant ETFs, too.

Bucket 1: Years 1 and 2

• $82,500 (11%): Cash: certificates of deposit, money market accounts, checking and savings accounts, and so on. 

Because this portion of the portfolio is in place to meet near-term income needs, the name of the game is stability; given today's low yields, its income production is bound to be modest.

Bucket 2: Years 3-12 $412,500

• $100,000 (13.33%):  Vanguard Short-Term Bond ETF (BSV)
• $50,000 (6.66%):  PowerShares Senior Loan Portfolio (BKLN)
• $150,000 (20%):  PIMCO Total Return ETF (BOND)
• $75,000 (10%):  iShares Barclays TIPS Bond (TIP)
• $37,500 (5%):  Vanguard Dividend Appreciation ETF (VIG)

For this component of the portfolio, current income production is the key goal, along with principal stability and modest capital appreciation. Because Vanguard Short-Term Bond is the most conservative holding in the portfolio, the assets in it will be first in line to refill bucket 1 when it's depleted. I've also included a fairly small stake in a bank-loan, or floating-rate, fund here; PowerShares Senior Loan Portfolio is the first and, to date, the only, floating-rate ETF. (Investors more comfortable with active management in this fairly new space should consider swapping in  Fidelity Floating Rate High Income (FFRHX).) I've used Bill Gross' PIMCO Total Return, or variants of it, throughout the bucket portfolios, mainly because I like the fund's flexibility to range across various bond market sectors and to shorten duration if need be. For protection against an unexpected jump in the rate of inflation, I've included iShares Barclays TIPS Bond. Because TIPS have enjoyed a strong performance runup during the past several years, I'd recommend that investors embracing TIPS at this juncture move in slowly, staging their purchases over a period of months. Bucket 2 also includes a fairly small stake of equity exposure via Vanguard Dividend Appreciation. Despite the presence of "dividend" in its name, its yield isn't especially high, but it does provide a high-quality take on the equity market.

Bucket 3: Years 13 and beyond: $255,000

• $120,000 (16%):  Vanguard Dividend Appreciation ETF (VIG)
• $50,000 (6.66%):  Vanguard FTSE All-World ex-US (VEU)
• $35,000: (4.66%)  PowerShares DB Commodity Index Tracking (DBC)
• $25,000 (3.33%):  SPDR Barclays Capital High Yield Bond (JNK)
• $25,000 (3.33%):  WisdomTree Emerging Markets Local Debt (ELD)

Bucket 3, the growth engine of the portfolio, aims to fund living expenses in the late retirement years. It's anchored by aforementioned Vanguard Dividend Appreciation, but investors who favor a plain-vanilla market-capitalization-weighted index could readily use a total U.S. stock market index instead. The portfolio also includes a modest foreign-stock stake, to provide exposure to blue-chip firms overseas. Three small positions in niche ETFs round out the portfolio. The PowerShares commodities ETF provides an additional guard against inflation while also diversifying the stock and bond components of the portfolio. And because bucket 2 generally focuses on high-quality U.S. bonds, SPDR Barclays Capital High Yield Bond and WisdomTree Emerging Markets Local Debt provide exposure to junk bonds and emerging-markets bonds denominated in local currencies, respectively.

A version of this article appeared Nov. 15, 2012.

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