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Investing Specialists

A Moderate Mutual Fund Retirement Portfolio in 3 Buckets

We update the performance--and make one small adjustment--to our middle-of-the-road portfolio.

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The going has gotten tough for retiree finances during the past decade and a half, with extreme stock market volatility, incredible shrinking bond yields, and pensions under fire. Whereas the previous generation of retirees may have been able to easily generate a livable income with a combination of bond and dividend payments, doing so today is a heavier lift. The S&P 500 currently yields a little more than 2%, and high-quality intermediate-term bonds hardly pay much more than that. That means income-minded retirees need to either have a lot of wealth, such that the current 2.1% payout on a 60% stock/40% bond portfolio is enough to live on, or venture into higher-risk parts of the stock and bond markets to amp up their income streams. 

That challenging environment probably explains why the bucket concept for retirement-portfolio planning has gained so much traction during the past several years. Pioneered by financial-planning guru Harold Evensky, the bucket approach is simply a total-return portfolio combined with a cash component to meet near-term living expenses. The long-term portion of the portfolio includes income-producing securities, but its main goal is to maximize long-term total return. Proceeds from the long-term portfolio--whether from income, rebalancing, or both--are periodically plowed into bucket 1 to meet living expenses.

I began writing about bucket portfolios in late 2012, providing sample mutual fund and exchange-traded fund portfolios for investors with varying time horizons and risk preferences. In last week's article, I reviewed how the aggressive mutual fund portfolio had performed since its launch, and I recommended a few small tweaks to reduce its interest-rate sensitivity. This week, I'll assess how the moderate version of the portfolio has performed since its debut in late October 2012 and recommend one modest change.

Everything in Moderation
Whereas the aggressive portfolio is geared toward retirees with a 25-year (or longer) time horizon and an ability to withstand the volatility that comes along with a 50% equity weighting, the moderate portfolio assumes a 20-year time horizon and less of an appetite for short-term volatility. It holds a roughly 40% equity stake, with the remainder of the portfolio in bonds and cash; it also includes a 5% position in a commodities-tracking fund to help provide inflation protection. (Although inflation is under control at the moment, inflation's corrosive effect on long-term purchasing power is one of the natural enemies of retiree portfolios.)

In response to last week's article and portfolio, several readers noted that they were uncomfortable with that portfolio's hefty bond allocation, and that complaint will almost certainly arise in relation to this more bond-heavy portfolio, too. That's not an invalid criticism: Just as declining bond yields have helped bonds generate strong returns for nearly 30 years, a rising-interest-rate environment is likely to result in meager returns from the asset class in the coming decade, or decades. 

That said, I'd point out that the main goal of this and all of the bucket portfolios is to help the retiree generate adequate cash flow using a diversified total-return portfolio while also preserving principal; capital appreciation above and beyond what's needed for the retiree's living expenses during his lifetime is secondary. Retirees for whom increasing principal is a key aim may well want to run with a higher equity weighting, and the various buckets in these portfolios can be adjusted higher or lower to suit a retiree's own goals and risk preferences. Additionally, even though the portfolios include funds that have Morningstar Analyst Ratings of Bronze or better, investors should feel free to employ their own favorite like-minded holdings in lieu of the ones featured here. 

Moreover, I've taken steps to ensure that the portfolio won't experience undue volatility if and when interest rates trend up. The fixed-income portion of the portfolio emphasizes shorter-duration and more credit-sensitive bonds, and the core intermediate-term fund has a good deal of flexibility to range across bond market sectors and maintain an active duration stance. (Duration is a measure of interest-rate sensitivity.) 

I've included three buckets for the moderate portfolio--geared toward the near, intermediate, and long term.

Bucket 1: Years 1-2

Original Portfolio

  • $100,000: Cash (certificates of deposit, money market funds, and so on)

Adjustments: None

The goal of this portion of the portfolio is to lock down money needed for near-term living expenses; income production is secondary.

Therefore, it holds true cash instruments rather than venturing into investments such as ultrashort funds, which may at times deliver higher yields but do so at the expense of principal volatility.

As I argued in this article, investors are simply not being rewarded for investing in these cash substitutes at this time. 

Bucket 2: Years 3-12

Original Portfolio

  • $75,000:  T. Rowe Price Short-Term Bond (PRWBX) 
  • $75,000:  Fidelity Floating Rate High Income (FFRHX) 
  • $150,000:  Harbor Bond (HABDX) 
  • $75,000:  Harbor Real Return (HARRX) 
  • 125,000:  Vanguard Wellesley Income (VWIAX) 

Adjustments: Use Vanguard Short-Term Inflation-Protected Securities Index (VTAPX) (or Vanguard Short-Term Inflation-Protected Securities Index ETF (VTIP) ), instead of Harbor Real Return.

Bucket 2 is designed to deliver a higher level of income than bucket 1; it also aims to preserve purchasing power with a dash of capital appreciation. The risk level in this portfolio stairsteps gradually upward. The T. Rowe Price fund would serve as next-line reserves in case bucket 1 were to become depleted and rebalancing proceeds and/or portfolio income were insufficient to meet living expenses. I've also included a slice of a floating-rate, or bank-loan, fund. This Fidelity fund, while potentially sensitive to the credit cycle, should hold its ground and even gain in a period of rising interest rates. Harbor Bond, a near-clone of  PIMCO Total Return (PTTRX), remains the portfolio's largest bond holding; I like the flexibility afforded by its core-plus mandate, which Morningstar's Eric Jacobson discusses in this video

As with the aggressive portfolio, however, I'd swap out Harbor Real Return, an inflation-protected bond fund, in favor of Vanguard's new short-term Treasury Inflation-Protected Securities fund. Although each fund invests in bonds whose principal values increase to keep pace with inflation, the Vanguard short-term fund delivers inflation protection without a lot of interest-rate-related volatility. Investors could also use individual I-bonds in this slot, too. 

A position in Vanguard Wellesley Income, which features a roughly 60% bond/40% stock allocation, is the longest-term component of the portfolio, providing both income and a shot of capital appreciation. 

Bucket 3: Years 13-20

Original Portfolio

  • $100,000:  Vanguard Dividend Growth (VDIGX) 
  • $100,000:  Vanguard Total Stock Market Index (VTSAX) 
  • $100,000:  Harbor International Institutional (HAINX) 
  • $50,000:  Harbor Commodity Real Return Strategy (HACMX) 
  • $50,000:  Loomis Sayles Bond (LSBDX) 

Adjustments: None. 

The long-term portion of the portfolio, geared toward growth, remains unchanged and generally mirrors bucket 3 of the aggressive portfolio. It includes a high-quality equity emphasis with its position in Vanguard Dividend Growth, but it also features broad-ranging sector exposure owing to the total market U.S. index fund. I'm hanging on to the position in Harbor International despite the impending departure of one of its comanagers; its remaining managers are experienced and employ a disciplined process. I also continue to like Loomis Sayles Bond for the long term. Although I've been concerned about investors' stampede into aggressive, credit-sensitive bond types, Loomis' flexibility to invest in foreign bonds, convertibles, and even stocks is an advantage. Just be sure to hold any such fund among your longest-term assets rather than in bucket 2. 

Keeping the position in Harbor Commodity Real Return, in place to provide some inflation protection, is more controversial. Not only have commodities prices slumped as a result of slack demand from emerging markets, but this fund's bond portfolio has also proved quite interest-rate-sensitive because it emphasizes TIPS. I'm retaining the position because our anticipated holding period for it is quite long--10-plus years--offering enough time to ride out interest-rate-related volatility and provide our desired hedge against inflation. 

Although the portfolio isn't designed to shoot out the lights during any short-term time period, it outperformed its custom benchmark by a tiny margin since it originally appeared in October 2012. The portfolio returned 10.5% from Oct. 25, 2012, through Feb. 14, 2014, whereas a basket of index funds mirroring its starting asset allocation (23% domestic stock, 12% foreign stock, 49% bonds, 5% commodities, and 11% cash) returned 10.3%. (Those figures include reinvested income, dividends, and capital gain distributions, but they do not include any portfolio withdrawals.) The bond portfolio's fairly short duration and stake in noncore bond assets such as Loomis Sayles Bond was a help; the position in Harbor International also beat a broad-market foreign-stock index fund.

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

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