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Bucket Portfolios for Retirement Income: Step by Step

Morningstar's Christine Benz walks investors through the basics of setting up and maintaining a 'bucket' retirement portfolio, including some of her favorite funds for retirees.

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Note: This video is part of Morningstar's September 2016 Retirement Matters Week special report.

The following is a replay from the 2015 Morningstar Individual Investor Conference. Some of the holdings have changed since this video was first published. 

Christine Benz: Hi, I'm Christine Benz for Welcome back to the Morningstar Individual Investor Conference. This session is called "Model Bucket Portfolios for Retirement," and in it, I'm going to talk about why the current yield-starved environment makes the idea of creating a total-return bucket portfolio so attractive.

I'll also talk about what bucket portfolios are, the logistics of creating and maintaining bucket portfolios on an ongoing basis, and in the tail-end of the presentation, I'll talk about some model portfolios that we have created that use the bucket strategy. I'll also share with you some stress tests that we've done on these portfolios. And then toward the tail-end of the presentation, we will take some user questions. So, you can answer a question by using the question-submission area to the right of your screen. If you'd like to download these slides so that you don't have to take notes as go along, you can do so by clicking the link below your viewer.

So, let's get right into the presentation. So, this is not a screenshot of the warehouse at Ikea. It's actually what retirement looks like for more and more folks. You've got a lot of people coming into retirement with the equivalent of a two-legged stool. Many people have heard about the three-legged stool for retirement planning--that means that people will come into retirement with Social Security, with some type of pension, and their own personal portfolio. Those are the three sources that they'll use to fund their income needs as they go along.

The problem is, as many of you know, that pensions have been slowly ebbing away. So, as of the most recently available data, just 18% of the population was covered by some sort of a pension. This is a sea change, really, that we've experienced over the past 30 to 40 years. This means that people need to have more of their income funded by their portfolios. It means that that portfolio needs to be larger, and it needs to last longer. It needs to deliver that lifetime income stream. So, this is a big headwind for many retirees, if they only have Social Security and their own retirement portfolios. So, that is a challenge.

Another challenge is what you see on the screen; it's a graph of what CD yields have done over the past 30 years, and you can see that they have drip-dropped steadily downward over the past several decades. So, if you were lucky enough to retire in the 1980s, you had the benefit of double-digit CD yields. You also had runaway inflation during that time. Today, retirees don't have inflation to contend with, certainly not to that extent, but they do have very, very low yields. If you shopped for any sort of money market account or CD recently, you can see that it's very difficult to even earn a positive return. At this point, the online savings banks probably offer you your best source of yield, but even there it's difficult to come up with much more than 1%. So, retirees who have been focused on keeping their money really safe, unfortunately, have been operating in a very constrained environment. It's been difficult to wring a livable yield out of a portfolio consisting of truly safe securities.

Now, if you're willing to take on a bit more interest-rate sensitivity in the portfolio, you can see that actually you can nudge up your portfolio's yield a little bit, but not a lot more. So, the Barclays U.S. Aggregate Bond Index yield has been bumping around 2% for the past year or so. If you are insisting on sticking exclusively with Treasury bonds, you'd have to settle for an even lower yield, currently about 1.6% on Intermediate Treasury Bonds. Muni bonds, you may be able to earn a little bit more, but they've had a tremendous rally, so yields are way down there as well. If you are willing to venture into longer-term high-quality bonds, if you're buying some sort of a long-term government index, for example, you are able to pick up a higher yield. The problem is that anytime you are into any sort of long-term product you're also into a lot of duration risk.

This next slide illustrates how that is so. One rule of thumb that we often tell investors to use when thinking about the impact of interest-rate changes and potentially higher interest rates on their portfolios is to think about running them through this sort of duration stress test.

So, when you're looking at this Barclays Long Term Treasury Index currently, it has a duration of about 15 years, almost 16 years. You're going to take that duration number for whatever bond product you're looking at and subtract from it the product's current yield. So, in this case, you've got a yield of about 2.5%. The amount that you are left over with is the amount that you would expect to see that product lose in that one-year period in which interest rates jumped up by one percentage point. So, that's a fairly big jump up in interest rates, but it's also a fairly big loss for the long-term Treasury holder. So, that would translate into roughly a 13% loss using the stress test outlined here.

One thing I often tell investors to do, though, is to run their individual holdings through this stress test. They may find, in fact, that the prospect of rising interest rates isn't as scary as perhaps they thought. So, when we look across a lot of core intermediate-term funds today, what we see are durations in the neighborhood of 4 or 4.5 years currently and current yields of about 2%. That would translate into a loss of about 2.5% or 2% for that holder of an intermediate-term bond fund.

So, run your holdings through this. Just bear in mind that this sort of stress test is going to be less useful when you look at some of the more supplementary bond holding. So, anytime you're looking at, say, a junk-bond portfolio or an emerging-markets bond fund, this is going to be a less useful rule of thumb, but it's certainly a starting point and does illustrate the risk of taking on too much interest-rate sensitivity in a bond portfolio today.

So, what if you are willing to reach for higher yields by looking at some lower-quality bond types? When we look at where fund flows have gone over the past several years, it does appear that more investors are comfortable with this trade-off than they are with taking a lot of interest-rate risk at this point. We're seeing more flows moving into these categories, although they've kind of ebbed and flowed with how yields have gone. But when we look at some of these products, certainly high-yield bonds, developing-markets bonds, you can see that the yields are appreciably higher. Same with bank-loan funds--not quite as high, but still higher. And multisector-bond funds like Loomis Sayles Bond (LSBRX). You can see that you can pick up a nice yield, certainly relative to what some high-quality products may give you.

The trade-off is that you also have more sensitivity to what's going on in the economy, certainly more sensitivity to what's going on in the equity market. And I've listed these product category averages for 2008 just to give you a feel for just how equity-sensitive some of these product types are. When equities are good, they tend to perform pretty well, but when equities are bad, they may conspire to deliver returns that are way below what many bond investors are expecting.

So, I think of these categories as nice supplemental holdings for fixed-income portfolios, but they are generally too volatile and they generally provide less diversification benefit than you'd get with a high-quality bond portfolio. So, these are interesting parts of a tool kit, but they're maybe not the whole bond tool kit.

So, how about dividend-paying stocks? Certainly in talking to investors, there is a lot of enthusiasm about including dividend payers in a portfolio and looking to dividend payers to fund your income stream as the years go by. I think that that's certainly a strategy, but I think investors also need to remember the potential for losses exists for dividend-paying stocks just as it does for the broad stock market. So, bear in mind that even high-quality dividend-paying portfolios will still suffer along with the equity market.

If investors have been through, say, a 2008 market with an equity-heavy portfolios and know that they can withstand the risks, that's potentially something to consider hanging onto or building, but I think it is important to remember that you need to have a high tolerance for volatility [if you're considering letting] dividend payers take the place of bonds in your portfolio.

So, looking at income alone and looking at the income constituents of a portfolio, income-oriented investors have really been left with a couple of choices over the past few years. They could either hunker down in the very safe securities and be prepared to make do on a very small payout--and that will only be workable for people with very high levels of wealth. Naturally, that hasn't been the direction that most retired investors have gone.

Or they need to get comfortable with taking more risk in their portfolios in the interest of generating a higher yield. When we look at where investor dollars have been going, we generally see more investors have been accepting this trade-off. They have been saying, "Well, in order to earn a higher yield, I am going to have to be able to withstand some volatility."

But we think there is a third way, and this is what we try to talk about when we work on this bucket strategy for retirement-portfolio planning. What it states is that, in addition to focusing on income, with the bucket strategy, I'm also going to focus on capital appreciation. So, I'm going to take a step back and think about, given my time horizon in retirement, how can I build a portfolio with the best balance of risk and reward, again, over that time horizon? So, I am going to include income-producing stocks and bonds, for sure, but I will also include securities that will mainly deliver capital appreciation.

When it comes time to take money out of that portfolio, I'm going to take those distributions from a combination of current income, maybe see how far my income distributions get me. Then, I'll take the remainder from rebalancing proceeds. So, once a year or so, I'll take a look at that portfolio. I'll look to highly appreciated parts of the portfolio and strip them back and use them to help meet my income needs--my cash flow needs, really. So, that's the basic underlying principle of the bucket strategy.

Another thing that we talk about, though, in the context of the bucket strategy is making sure that you have some liquid assets set aside. So, there will be times when there are no ready rebalancing proceeds to be drawn from the longer-term portion of the portfolio, so you set aside one to two years' worth of living expenses in true cash instruments. And yes, they will be yielding next to nothing, but the idea is that you're near-term income needs are covered, so you can let the longer-term portion of your portfolio do what it's going to do. You can maybe look to taking distributions from it at a time when it's more favorable to do so; you never have to tap anything when it's down in the dumps.

So, those are really the key tenets behind the bucket strategy for retirement-portfolio planning, a capital-appreciation and income-oriented portfolio. We draw income and rebalancing proceeds from the portfolio as the years go by, and we bolt on that cash bucket to help stabilize us and tide us through weak spots for the long-term portfolio.

So, here's a basic bucket setup in my model portfolios: I've generally used this construct in creating the portfolios, and I'll delve into each of these buckets, one by one. So, bucket one, this is your safety piece of the portfolio. We are not taking any chances with this piece of the portfolio, because we want it to be there when we need to meet our living expenses. So, we're holding true cash instruments, understanding that this is dead money or worse over our time horizon but also understanding that this is going to provide us with some valuable peace of mind.

We are not staking too much in bucket one, even though peace of mind is a valuable thing, because there is an opportunity cost to having too much in cash. And it's one that we've seen pretty clearly over the past several years that if you are holding cash versus securities with more appreciation potential, you are stuck with a very low yield and you could actually have a negative return once inflation is factored in. So, you don't want bucket one to be too large--one to two years for most retirees is plenty.

Bucket two is taking a little bit more risk with this portion of the portfolio, so this portion of the portfolio consists primarily of high-quality fixed-income instruments. Yes, yields aren't terrific here either, but they will be better than what you will earn in the cash portion of the portfolio. So, here, we're thinking of short- and intermediate-term bond funds. We are also thinking about adding a little bit of inflation protection to this portion of the portfolio, as well as potentially a little bit of equity exposure.

So, in my model portfolios, I've included either a dash of direct equity exposure or perhaps a conservative-allocation fund to give us a little bit of a growth potential, because the time horizon for this piece of the portfolio is roughly three to eight years of retirement. So, we can withstand a little bit of volatility, and we want to have a little bit of growth come out of this piece of the portfolio as well.

Bucket three, this is the growth engine of the portfolio. The idea is that this is going to be the part of your portfolio to carry you through years 11 and beyond of your retirement. So, you are going to keep the money predominantly in equities. Here, I would argue for a pretty simple, pretty vanilla globally diversified equity portfolio. To the extent that you own individual stocks--and I know many of our viewers do--you'd want to hold them in this bucket as well.

You would also want to think about holding other assets in this part of the portfolio. So, that would mean commodities, it would mean real estate, precious metals--to the extent that you held them. You'd want to hold them in bucket three. You'd want to have that very long time horizon in mind for this money, because you'd want to be able to ride through the periodic downturns that you would inevitably experience.

You'd also want to hold higher-risk bond funds in bucket three. So, anytime you're looking at some of those lower-quality products that we saw in one of the earlier slides--categories like high-yield bond, multisector bond, emerging-markets bond--I would give myself a nice long time horizon for those assets. I'd hold them in the latest part of my portfolio where I do have, say, a 10-year or longer time horizon. So, that's the essence of the three bucket system. Retirees may, instead, use a two bucket system, where they've just got that cash piece along with a total-return portfolio; that's a reasonable way to do it as well, but these are the basic building blocks of a bucket portfolio.

So, how do we maintain this thing? Because as we go along, the idea is that we're spending the assets in bucket one, but periodically we need to refill it. We don't want to come to the end of the year and have nothing in bucket one because we've spent it all. We want to periodically be moving money into bucket one. There are really a few different ways to think about bucket maintenance. One is what we call the strict constructionist total-return approach, and so that would mean that you would reinvest all of your dividend and income distributions back into the positions and then look to pure rebalancing to fund the living expenses. That's one way to do it.

Another way would be sort of a hybrid way, and that would be to spill all of your income and dividend distributions as they occur from buckets two and three straight into your cash fund--into your bucket number one. And then, if at the end of the year, you find that you need additional monies to fill up bucket one, you can then do your rebalancing and use the proceeds from selling highly appreciated positions to move those monies into bucket one to further top it up to where it needs to be. What it doesn't entail, when we talk about bucket maintenance, is that even though we've got these three-bucket system, we're not constantly moving money from bucket three to two and two to one, and there are a couple of reasons why we're not doing that.

One is that it entails a lot of maintenance. If you were to look at such a strategy, you'd step back and say, "Well, that's really almost a full-time job--that's not how I want to be spending my retirement." And the other issue is that, if you were sort of dogmatically pulling from the different pools of money, there may be times when you don't want to do that. So, there might be years, for example, where pulling any money from bucket three is not something you'd want to do because bucket three is down in the dumps.

So, that's not what we're doing with bucket maintenance, nor are we sequentially spending through buckets one and two and then moving on to bucket three. And the reason is pretty obvious: Toward the end of our retirement, we don't want to have spent through all of our safe securities. We don't want to have spent through our cash piece and our bond piece and suddenly be left with a lot of money in equity assets in our later retirement years. So, that's why we're not using that maintenance strategy. Instead, I would espouse either that strict constructionist total-return strategy, whereby you are reinvesting all dividend and income distributions, then periodically rebalancing. Or using that hybrid approach, where you're seeing how far your income distributions will take you and then using rebalancing to sort of fill you up to where you need to be.

So, let's take a look at a specific example. A retiree, for example, would want to fill up bucket one coming into 2015, and they would look back on their portfolio performance from 2014 to determine what they do. So, using the hybrid method of refilling bucket one, we would see that if we had a 60% equity/40% bond portfolio, that portfolio currently yields about 21% or 22%. Assuming that the desired cash flow from the portfolio was $40,000, that income distribution gets us a little more than halfway there in terms of what we want to achieve, in terms of refilling bucket one. So, from there, we would look to rebalancing to make up the difference.

So, in the case of the 60-40 portfolio, it turns out that 2014 was a pretty good year for both the equity and the bond market. So, the retiree at this point would be able to rebalance, would be able to pull money mainly from equities to rebalance. And rebalancing that portfolio would yield a distribution of roughly $80,000; he or she could take part of that $80,000 to get to the $40,000, so about $18,000 more from those rebalancing proceeds to get to that $40,000 desired to refill bucket one. And then any remaining dollars would be reinvested in the long-term portfolio.

So, we're simultaneously both funding our near-term income needs, we're refilling bucket one, but we're also sending some money to help fund the portfolio's long-term growth. So, that's a basic bucket illustration. Of course, in reality with your portfolio, assuming you have a more complicated portfolio than this, you may have a little more complexity going on. But that's a very simplified example of how it would work for someone who wanted to use the hybrid approach.

So, we have created three series of model bucket portfolios so far. The first series, which was launched in the fall of 2012, was a portfolio consisting of traditional mutual funds--actually a series of portfolios. So, within each series, we have an aggressive, moderate, and conservative version. The idea behind this portfolio was to think about a tax-deferred portfolio. So, we are not managing this particular portfolio for tax efficiency. We're assuming that a retiree holds it in some sort of tax-deferred account.

For the second portfolio series that we introduced around this bucket concept, we used all exchange-traded funds. Again, this portfolio was created for tax-deferred accounts, and we created an aggressive version, a moderate version, and a conservative version. The most recent bucket portfolio series is a portfolio that was created for taxable accounts. So, here, we are managing with tax efficiency in mind. Again, we've created aggressive, moderate, and conservative versions. And investors can kind of look at their own situation to determine whether the aggressive, moderate, or conservative is the best fit for them. The taxable portfolio was just introduced this past February.

So, the goals of these portfolios are multiple. One of the big ones is to illustrate how this bucket strategy would work on an ongoing basis--to illustrate the logistics of managing a total-return portfolio. We also wanted to showcase how investor portfolios should include healthy equity complements, even for people who're in their later retirement years. So, all of our portfolios do include healthy doses of equities. And another goal of the portfolios was to show investors how to use some of our lists, some of our analysts' Gold-, Silver-, and Bronze-rated funds--how they might be put together into a portfolio context. So, those are the goals of creating the model bucket portfolios. We'll manage them on an ongoing basis and, certainly, alert investors if we're planning to make any changes to them.

Our model bucket portfolios are not designed to beat any other retirement strategy that you may have never heard about. Really, the key goal of these bucket model portfolios is for educational purposes. If you have a portfolio strategy that's been working for you--and certainly if you have individual funds or stocks that you've held for many years and you've had good success with the strategy that you've been using--we would never suggest that you completely upend that strategy to implement our approach. The idea is really to illustrate that if this income model is difficult, at best, for retirees today, how can you take a total-return model and make it work for you during retirement.

The other thing I would point out about our bucket portfolios is that they are not designed to require a lot of ongoing maintenance. So, retirees shouldn't have to stay super plugged-in to our website in anticipation that we'll make major changes. We'll make changes only on an as-needed basis, when fundamental circumstances dictate. So, if there's been, say, a change in the management or strategy of one of the funds that we have held and there is something that derails our thesis for that investment, we will consider making a switch; but we will not make regular changes. We also will not make changes based on market timing or tactical factors.

We'll certainly pay attention to what's going on in the economy and in the market environment. We'll try to be valuation-sensitive, and that's one of the things that we do when we think about rebalancing that portfolio. We're sort of inherently plugging in to valuations, but we're not going to incorporate any sort of top-down view into these portfolios. Instead, we'll use the work that a lot of our colleagues have done at Ibbotson Associates, the great work that they've done in the area of asset allocation. So, we'll try to focus on coming up with what is the right asset allocation for retirees with various timelines, but we won't be top-down at all when thinking about managing these portfolios.

So, in creating the aggressive versions of these portfolios--and that's really what I'll be focusing on in the examples that I've provided here, the aggressive versions--we've made a few assumptions about the retirees who we'll be focusing on here. These assumptions may or may not fit your situation. If you are, say, an older retiree, you may want to gravitate toward the moderate or the more conservative versions of these portfolios.

But for the aggressive portfolios, we've made a few specific assumptions. We've assumed that we're looking at a 65-year-old couple with a roughly 30-year time horizon. We are assuming that they come into retirement with a $1.5 million portfolio. We assume that they're using the 4% guideline for managing their ongoing distribution. So, they are going to take 4% of their initial balance of that initial $1.5 million balance, and they're going to gradually inflation-adjust that amount as the years go by.

We are also assuming that they have a fairly high risk tolerance. So, they have that 25- to 30-year time horizon. They are starting out with a 50% equity/50% bond mix. Again, that may not fit your own situation, but those are the assumptions that we've made in putting together the aggressive versions of these portfolios.

So, looking at our traditional mutual fund portfolio, this is created for tax-deferred accounts, as I said. This is the first series that we launched. You can see that we have the income needed for years one and two of retirement stashed in true cash instruments. So, we're not taking any chances with this portion of the portfolio. We've got about $120,000 in cash for years one and two of retirement.

For years three through 10 of the portfolio, we're taking a little bit more risk. And with this portion of the portfolio, I've kind of stair-stepped it by risk level. So, we start with short-term bonds. In case we've depleted bucket one and nothing is yielding any decent rebalancing proceeds, we are potentially going to step into bucket two and take some short-term bond fund monies out to refill bucket one if we need to.

So, we start with short-term bonds; we move into some sort of a core intermediate-term bond funds. In this case, I've used the PIMCO-managed Harbor Bond (HABDX) to serve as our core bond position. We're also adding a little bit of inflation protection to this portion of the portfolio because we have a slightly longer time horizon for it. We need to make sure that we're adding some inflation protection. Treasury Inflation-Protected Securities, of course, are pretty unpopular right now. Not a lot of people are concerned about inflation, but I think it's realistic over a longer time horizon to start factoring in the need for inflation protection.

So, I would include some short-term TIPS exposure. The fund I've used throughout the portfolio is Vanguard's relatively new Short-Term Inflation-Protected Fund (VTIPX). The reason I like it is that core longer-term TIPS products include a lot of interest-rate sensitivity--a lot of volatility potential. This fund, in particular, isolates inflation and does provide some inflation protection without a lot of interest-rate-related noise.

I've also included a conservative-allocation fund as kind of the caboose of this portion of the portfolio. So, here, I've used Vanguard Wellesley Income Fund (VWINX). It's predominantly fixed income but does also include a sleeve of equities, including some foreign equities. So, this is to give a little bit of a growth lift to this portion of the portfolio, because even though income and stability are key goals here, we also want a little bit of growth from it.

And bucket three of our aggressive mutual fund portfolio for tax-deferred accounts is predominantly equity exposure. You can see when you look across these holdings, I've generally tried to give them a high-quality cast. So, the linchpin of this piece of the portfolio and our model portfolios is Vanguard Dividend Growth (VDIGX), which is kind of a high-quality cut of the total market; but we've also included a bit of total U.S. market exposure to give us some of those growth-year companies that may not be included in Vanguard Dividend Growth. So, we've included some total U.S. market exposure as well.

We've included an active fund for international exposure, but you could just as easily use some sort of index product. The idea there, though, is that we want to keep the equity portfolio, overall, somewhat high quality versus what we might recommend for someone in his or her 20s or 30s. So, you can see that we're generally pretty light on small caps here. The investor in the Total Stock Market Index Fund (VTSMX) is certainly getting some small- and mid-cap exposure, but it's not a big thrust for this particular portfolio.

We've also included what I would consider kind of a noncore bond type. This is a multisector-bond fund, Loomis Sayles Bond. One of the reasons I like it is because it's flexible, it's opportunistic, it's value leaning, and it really can invest in an array of different more aggressive bond fund types. It can also hold some equities. So, it can have nondollar bonds; it can have junk bonds. It's wide ranging, but it is a fund that has the potential for tremendous volatility and will tend to sync up a little bit more with equity market performance than it will with bond market performance. So, I think it's important for any investment like this, whether you are using this particular fund or something like it, to think about having a nice long time horizon in mind.

Finally, I have included a little bit of commodities exposure in this portion of the portfolio. The basic idea is that, as inflation increases, and as you are having to pay higher prices for stuff that you need to buy, that commodity-tracking investment helps offset that need to pay higher prices. So, you are sort of paying out of one pocket higher prices, but you are potentially earning higher prices on that commodities-tracking investment.

This is one piece of the portfolio that, since we created the portfolios, certainly hasn't delivered much in terms of return. In fact, it's been a negative returner for us over our holding period. But we do think that investors are potentially underestimating the role of inflation. So, it's one thing to think about adding to a retiree portfolio; but commodities are very volatile, so again you'd want have that nice long time horizon in mind.

Looking at our exchange-traded funds portfolio, again, created for tax-deferred accounts, you can see really a similar complexion for buckets one and two, relative to what we had in that traditional mutual fund portfolio. So, we've got that true cash piece of the portfolio. We're not monkeying around with it. We're not taking any risks whatsoever with that portion of the portfolio.

Bucket two, again, stair-stepped by risk level. So, starting with our high-quality short-term bond fund, moving on to some sort of an intermediate-term product, including some sort of short-term inflation-protected securities investment. And also because there is no direct analog for Vanguard Wellesley Income, which we included in the mutual fund portfolio, we included a dash of equity exposure here.

So, $80,000 is going into Vanguard Dividend Appreciation (VIG), which, while it's an exchange-traded fund, is kind of similar to Vanguard Dividend Growth in that the fund is prioritizing companies that not just have current dividends but, importantly, have shown an ability to raise those dividends over time. So, this is a strategy that tends to give investors a balance of some income, certainly not income that's high in absolute terms, but some income as well as some capital-appreciation potential.

So, you can see in bucket three of this portfolio, here, again, we've got the lion's share of assets in equity investments. We've got a sizable position in Vanguard Dividend Appreciation, which is the fund I just talked about. We've also got a share of the portfolio in a total market index tracker. We've got a piece of the portfolio in a foreign-stock index fund--again, a very low-cost foreign-stock market tracker.

And here is another area where we couldn't find direct analogs for that Loomis Sayles Bond that we had in our original mutual fund portfolio, so we cobbled together some supplementary fixed-income types that investors might think about. So, we've got some high-yield exposure via a high-yield ETF; we've got some emerging-markets debt denominated in local currencies; again, we've got the commodities piece of this portfolio.

So, these are some ideas to consider for the long-term growth portion of an ETF investor's portfolio. Here, again, we've put together bucket three with a pretty long time horizon in mind. We know that this will be the most volatile piece of our portfolio, but we also know that it will be the highest returning, certainly if market history is any guide. So, that's the exchange-traded fund portfolio for tax-deferred accounts.

The last and most recent portfolio that we created is a portfolio consisting of tax-efficient investments. So, this is for the taxable portion of your portfolio. We know that a lot of our readers are really attuned to this issue of tax efficiency, of managing their portfolios for aftertax return. And we also know that more-affluent retirees tend to come into retirement with a big share of their portfolios in their taxable accounts.

So, the idea here was to take the bucket approach and structure it in a tax-efficient way, and you can see there are really a lot of similarities. True cash being held in bucket one; we haven't really bothered with municipal money market securities, in part, because yields are lower than one might get with other types of cash instruments. But we have also included that bucket two that includes short-term and intermediate-term fixed-income instruments. And then bucket three, for this final portion of the taxable portfolio, is predominantly in equities.

Here, I wanted to point out, whereas we used municipal investments in the bucket two for the taxable portfolio, in bucket three for the equity piece we focused on a combination of a traditional index mutual fund that tends to be pretty tax-efficient--this is for the international piece--and then we've used tax-managed funds to provide the U.S. equity exposure. So, we've included some large-cap exposure, Vanguard Tax-Managed Capital Appreciation (VTCLX), and we've also included a slice of Tax-Managed Small Cap (VTMSX) as well. These funds are actively managed on an ongoing basis to help reduce the drag of taxes.

We've run some stress tests on these portfolios. The goal certainly hasn't been to showcase how smart we are. Really, the point of the stress test--and you can find all of the spreadsheets on our site and you can kind of look at them on a year-by-year basis--but the point of the stress test was just to look at how these portfolios would have held up over various market environments. So, the first stress test that we created looked at the period from 2000-14, and what we found was actually a pretty encouraging picture. And you can read about the rebalancing rules that we used to keep these portfolios maintained on an ongoing basis.

But when we look at the results, what we saw was that the $1.5 million portfolio ended comfortably above our starting value and, importantly, it also supplied us with our desired income distributions as the years went by. So, this is a really encouraging picture. A couple of important caveats; arguably, the time period we examined for this particular stress test showcased a very good environment for both stock and bond investors. So, this probably makes us look smarter than we actually are. The results are very, very good, in part, because bonds cooperated and mainly, in part, because the equity market was so strong.

I would also point out that, over the time period examined, the bucket one--that cash piece--was, in fact, a drag on our performance. So, think about the past decade and a half; it was a period in which interest rates declined. That did nothing but hurt the holder of cash who had to settle for lower yields; but it really helped the bond investor because, even as he or she, too, had to settle for lower yields, the bond investor got some capital appreciation as interest rates declined. So, that's something to keep in mind.

When I think about what total conclusions we can draw from these stress tests, the main advantage of bucket one, at least over the environment that we've looked at, is not in the return-enhancement area; it's mainly in providing peace of mind. A couple of other conclusions: The real-life portfolios that you might run for yourself are no doubt going to be more complicated because you will have three types of portfolios--perhaps you might have Roth, taxable, and tax-deferred. So, the logistics of managing your own portfolio may be difficult and may be more complicated.

Finally, the thing to keep in mind is that some portions of the portfolio were, in fact, a drag on performance during the time period examined, specifically some of the things that we had layered on to provide inflation protection. They really haven't cooperated; but over time, we do think that they are worth holding on to as a component of the portfolio.

The last point I would make is that all of these simulations, I think, underscore the value of creating your own drawdown strategy--thinking hard about what is my strategy for extracting cash flow from my portfolio as the years go by. I hope that the model bucket portfolios help give you some food for thought on that front.

So, with that, we will take a pause here. My colleague, Jason Stipp, has joined me, and he's brought some questions. I know that there have been some questions coming in, and I receive a lot of questions about these portfolios on an ongoing basis. So, I'm happy to tackle them now. Jason, thank you.

Jason Stipp: Great presentation, Christine. It's such an important topic. Thank you for all of the insights there. We did get lots and lots of questions. So, I'm glad to bring many of those to you today. The first one was about the number of buckets, and the viewer mentioned that Harold Evensky is talking now about two buckets--a two-bucket strategy. Can you do a two-bucket strategy and make this work?

Benz: Absolutely. And I should have given Harold Evensky credit at the outset of this presentation, because this idea of bolting on a cash bucket to a total-return portfolio is all Harold's. He was the originator of this bucket concept, and he says he wasn't smart enough to brand it as such. But he's a very smart and influential financial planner. And he, in fact, does just use two buckets. So, he thinks about a total-return portfolio and shakes off rebalancing from that portfolio as the years go by, along with the cash bucket. The last thing you want is to have this become too complicated. So, I think in a lot of ways his idea of having just two cash buckets is just fine.

One reason I use three is, when you think about rebalancing, when you have bucket two, which is predominantly bonds, as well as bucket three, which is equities, you can make it crystal clear to see which bucket you should leave alone because it hasn't appreciated any over the past year and which you can maybe touch to yield some rebalancing proceeds. So, that's one reason I've used three, but two is just fine, too.

Stipp: We had a question about balanced funds and how you might use a balanced fund in the bucket portfolios. You do have some usage of balanced funds in buckets. So, what's you're thinking on that?

Benz: So, I think the idea there is that you want some equity exposure balanced with a little bit of risk reduction that you get through fixed-income instruments. One related question I've gotten on this, Jason, "Is forget all these buckets, how about just a balanced portfolio? Because essentially what you're showing me is some sort of hybrid stock-bond portfolio. What about an all-in-one portfolio, whether a target-date fund or a balanced fund or whatever it might be?"

To that, I say, while I love the simplification piece, the risk is when you're looking at any sort of balanced product, it's not being smart about where it goes for distribution. So, if you need your money out of a balanced fund in 2008, well, you want to leave your equity piece alone. You would probably want to be pulling money from the piece of portfolio that had appreciated at least a little bit. That's not the sort of discretion you enjoy when you have an all-in-one product.

So, I would be careful about simplifying too much. One thing I would say, though, is that there are some products that have begun hitting the market that kind of simulate this bucket strategy in an all-in-one fund. And the closest approximation, I would say, to what I'm trying to do with these bucket portfolios is Vanguard's Managed Payout Fund (VPGDX), where it is, in fact, attempting to be smart about distributions. It's attempting to leave depressed pieces of the portfolio alone and pulling income distributions from the most opportune places.

Stipp: So, having some more dedicated funds allows you to be more surgical--

Benz: Exactly.

Stipp: --To go in and rebalance, and we actually saw that in the bucket portfolio stress tests. Some funds really were under pressure and other funds were really doing well. And then you can move money between those and, essentially, be kind of a contrarian as you're doing it.

Benz: That's right. One thing I would say: We did run a stress test of a balanced portfolio of a true balanced fund with a cash bucket, and what we did see is that it did not dramatically underperform our more complicated bucket approaches. So, less is more. And someone who's in search of simplicity, I applaud that because that's something you need to be thinking about, particularly in your later retirement years.

Stipp: I want to talk a little bit about bond funds that you use. The viewer question we had was about multisector-bond funds. And you think about those differently than you would a core bond fund, as far as the bucket that they should go into.

Benz: I do. And I hate to keep talking about 2008, but I think it provides a great lens to view how an investor might think about some sort of a product like that. You saw very equity-like performance from multisector funds during that period. The losses certainly weren't on par with what equityholders had, but they directionally were certainly similar--and in most cases, double-digit losses from multisector products.

So, I do think, particularly now, when we've seen a pretty good rally in anything with a nice yield attached to it, I think investors looking at those products today, even though their yields can be pretty attractive, you want to have a nice long time horizon in mind for that money. If you are looking at money that you expect to tap within the next, say, five years, I would keep it high-quality even though you are picking up some interest-rate-related volatility there as well.

Stipp: And a related question: Some of the buckets have a fairly high allocation to fixed income and, as we know, this is an area of the market that could be under some pressure. How should we think about those fixed-income allocations when it doesn't seem like maybe a great time to have so much money in bonds?

Benz: That's right. I think this is a natural concern. We saw the forces that are working against bond investments today, particularly the interest-rate-related concerns. So, that's one of the reasons why we do have cash in this portfolio. But I do think bonds will continue to fulfill the role they've historically done, and that is the role of stabilizer for the equity piece. So, the equity piece, when you look at what you might expect to be their future returns, certainly the long-term picture there is much more optimistic; but the volatility is much higher, and I do think that a high-quality equity portfolio will continue to have that potential to even gain in periods of equity market weakness. So, I do think that investors need to hold at least some core fixed-income products--kind of hold their nose and make room for them--because I think that they will be grateful they have it in a difficult environment.

And the other thing to point out is that, even though bonds are scary, equity market valuations certainly aren't cheap either. So, I would not be surprised--in fact, 2015, so far, has started out with a fair amount of volatility--I wouldn't be surprised to see that persist or even pick up over the next few years.

Stipp: Well, and the other point is, we've been worried about fixed income for a long time, yet we see years like last year where fixed income performs pretty well. So, there is a diversification benefit. We don't know necessarily when people will get scared and there will be a flight to quality, so having that slug of bonds, even if the broader macro environment makes it seem like it's not a great time, can still benefit you.

Benz: Absolutely. And I think building in a little bit of flexibility to your fixed-income portfolio [is important]. That's one reason, at least, in the active portfolio we did include Harbor Bond, although one could reasonably use a fund like MetWest Total Return (MWTIX) or Dodge & Cox Income (DODIX). But really, a flexible approach, to me, makes a lot of sense, given the uncertain future prospects for fixed income; you want a manager who could potentially hold a little bit of foreign-bond exposure, could shorten duration versus what you might have in sort of Barclays Aggregate Bond tracker.

Stipp: Christine, another viewer asked, "What about individual bonds? Why bond funds instead of individual bonds? If I hold the individual bond and interest rates go up, I don't have to sell that individual bond, so I don't have to take a capital loss and I can continue to collect the income." What do you think about that?

Benz: A couple of thoughts on that: One is that I would not recommend that individual investors buy individual bonds in any other sector than Treasuries, because I think there are complexities there and that there are certainly trading costs that can weigh on the yield that the smaller investor earns from the more specialized bond types. So, once you move outside of Treasuries, I actually would not recommend individual bonds.

But even with Treasuries, you have to think about, if you're locking in some sort of 1.5% yield today, in order to get out the money that you put in, you need to put up with that 1.5% yield. In the meantime, rates could move higher, but that's your yield. Otherwise, you've got to settle for some sort of loss of principal, if you need to get out of that thing prematurely. So, bear that in mind. Bear in mind the opportunity cost that you would face. That's something that you wouldn't necessarily face as an individual investor. Your bond-fund manager could trade into the new higher-yielding securities as they become available.

The other thing I think it's important to remember is, by the time someone builds a portfolio of individual bonds that's adequately diversified and that is perhaps laddered across different maturities and different credit-quality exposures and so forth, that person ends up with something that looks and feels a lot like a bond fund but requires a lot more oversight. So, that's another consideration as well.

Stipp: Christine, there is a question I know that you've also been getting from readers as well about the PIMCO funds and the PIMCO ETFs in your bucket portfolios. We saw a lot of change at PIMCO over the last year--dramatic change, in fact. What's you're thinking about keeping those funds in the bucket portfolios right now as that firm go through a transformation?

Benz: We have kept them in the portfolios. The funds did receive downgrades as a result of some of the turmoil associated with Bill Gross leaving PIMCO for Janus in September of 2014. And this is an area where I communicate a lot with our analysts about what's going on with the funds that we would be recommending in these portfolios. They have had a lot of ongoing communication with PIMCO; I think they feel that the personnel situation there is pretty stable. They're comfortable with the experienced managers running the funds. In the portfolios, I've got Harbor Total Return, I've also Harbor Commodities product (HCMRX); both of those funds are no-load funds run for Harbor by PIMCO. But our analysts are comfortable with the stability and the tenure of the individuals running those two particular products at this point.

I think that the real wild card, on an ongoing basis, is the fact that we have seen some significant outflows from some of those funds. And I know that this is an area that our analysts have been really communicating with PIMCO about, because there's the potential if PIMCO has to sell securities that it might rather keep in order to meet these redemptions, it starts affecting the strategy of the portfolio and it starts affecting performance potentially.

To date, PIMCO has done a pretty good job of keeping liquid assets set aside to meet investor redemptions, but that's a situation where we're watching closely. For investors who aren't comfortable with what they've seen go on at PIMCO, I certainly have no trouble recommending some of our other core fixed-income funds. I mentioned a couple of them already; MetWest Total Return and Dodge & Cox Income would be good choices for investors who feel a little bit queasy about what we've seen at PIMCO.

Stipp: What about a bond index fund? Because it has a different composition than many of the active funds, would you recommend shifting into an index fund? There are nice low fees, but it is a different kind of fund than the active ones.

Benz: It's a trade-off. You're absolutely right: When you look at the complexion of, say, a Barclays Aggregate Bond tracker, what you have is a heavy dose of government and government-related bonds--about two thirds of exposure, currently. So, that does potentially give that product a longer duration than perhaps some of these actively managed products have today. So, that's a risk, that it could be a little more vulnerable in a period in which rates rose.

The trade-off is, when we look at those bond market indexes in periods when the equity market is under duress, that product is doing exactly what I would want it to do; it's even gaining money in those periods. So, in 2008, for example, that bond market index tracker was very difficult for any active fund to beat, because most funds weren't as conservatively positioned in terms of their credit-quality exposures.

Stipp: Another viewer question, Christine, is related to cash and bonds and the fact that yields are so little--or nothing, essentially, on cash. The viewer said, "Why have that money dead"--money, essentially, is what the viewer said--"when I could invest in high-quality dividend payers, collect that dividend income, and use that as my income stream and get growth from those stocks as well?"

Benz: Well, I think dividend payers certainly fulfill a valuable role in the portfolio, whether you hold them individually or you hold them as part of a fund. I think they make a world of sense in retiree portfolios. I would just make sure that I had an adequately long time horizon for them, and I would also hold that cash bucket alongside my total portfolio, whatever its composition, whether it's all dividend-paying stocks or some sort of a balanced composition. I'd hold that cash piece aside to help me regroup from those periods when the equity portfolio perhaps wasn't performing that well or if something happened to the income distributions from those equities.

So, think of 2008: Bank stocks cut their dividends dramatically during that period; rates declined during that period. If you're looking at some sort of bond portfolio during that time, you had declining rates. If you were trying to subsist on income alone, you'd really have to figure out your strategy really quickly or cut your standard of living.

One reason I like that cash piece--even though it is, as the viewer said, "dead money"--is that it gives you a little bit of a cushion, some time to regroup, during those difficult periods when your income distributions are under stress.

Stipp: The value in it really is not what it's yielding, which is nothing essentially, but what it does for you during times of really rough markets. And even high-quality companies in 2008, they didn't sell off as much, but they still sold off. So, it's easy sometimes to forget just how badly the market can get hit in rough times.

I also had another question from a viewer about bucket one and when I should start thinking about filling bucket one as I'm approaching retirement--sometime in my 50s or in my 60s. How soon before I retire should I get that bucket set up and ready to go?

Benz: I would say that you don't want to do it prematurely. I would say, while you're still working, it's fine to stick with just that emergency fund in terms of your cash. But probably when you are within a couple years of retirement, it makes sense to start thinking about not just building those liquidity reserves but also thinking about time-horizon segmenting the portfolio if you are attracted to this bucket idea and thinking about setting it up along the lines of what we've outlined in our model portfolios.

Stipp: Christine, a question from of a viewer who sounded a little bit concerned about having not saved enough: "I'm worry that I saved too little for retirement, so should I take greater risk now as I'm approaching retirement to try to make up some lost ground?"

Benz: That's a great question, and it's a really common one. When we look at data on the extent to which people are ready for retirement or not, what we see is that a lot of people don't have enough. We talked about the virtues of working longer as well as the potential drawbacks of working longer in the previous session. Even though working longer is one of the best possible things you can do to help your portfolio last over time, it may for whatever reason, maybe some reason that you can't foresee right now, it may not be viable for you.

So, certainly, that's one backup plan that I would consider in addition to potentially pulling some of these levers. I think you could theoretically tweak your asset-allocation exposure versus what I might outline in a presentation like this. You could potentially add a little bit more equities. But I can't underscore enough how equity market valuations aren't what they once were. So, when we look across our analysts' price/fair values for the companies that they cover, they've been bumping over fair value, not appreciably so but somewhat, for the past few years. When you look at Shiller P/E, you see an even scarier number.

So, I think investors really need to be careful about adding to their equity risk at this point in time. An investor who perhaps has undersaved may have a better buying opportunity. It doesn't strike me as a great time to load up on equities, nor does it suggest you should just batten down the hatches and be really conservative. But it does suggest that probably, if you're going to tilt your portfolio in a more equity-heavy direction, I could think of better times to do it.

Stipp: So, we had several questions about pension income, and you mentioned this is becoming less a part of the retirement three-legged stool now. But some folks still do have pension income; some folks have income from annuities. There are questions about which bucket is that income. Is that in bucket two? Is that part of bucket one? How should I think about it when I'm implementing a bucket portfolio strategy?

Benz: So, it's not part of any of these buckets. What I would do when I talk about implementing a bucket strategy is think about how much income you need, subtract from it what you're getting from Social Security, what you're getting from that pension or maybe some sort of fixed annuity that you have--those stable lifetime sources of income--subtract it from your income needs. The amount that you are left over with is the amount that you need your portfolio to replace. Then, take that portfolio and think about, "Well, given my time horizon, given my anticipated spending needs from that portfolio, what's the best asset allocation for me?" For people who have pensions and are really drawing very lightly from that portfolio on an ongoing basis--for instance, if Social Security and/or a pension supply most of the desired living expenses and the portfolio withdrawals are very, very minimal--that would turn back into a very aggressive-looking bucket portfolio.

So, if you're just taking very small shares of bucket one, and bucket two is not very large in dollar terms either, bucket three is really your whole kitty because you're spending so lightly from this portfolio. The higher pension would tend to influence a more aggressive allocation.

Stipp: It could also mean potentially more money for your heirs as well afterward.

Benz: Yes.

Stipp: Another question that we had was from a viewer who said that over the years she has accumulated a lot of different investments from a lot of different fund companies: Vanguard, T. Rowe, Mairs and Power, Dodge & Cox, and plus a little from Fidelity. The person wants to monitor less, wants to have less paperwork. What's a good way to think about streamlining, though? Because there are a couple of funds that this viewer really likes and wants to keep. How do you draw the balance between really liking a Dodge & Cox fund but wanting to get all of your money with Vanguard, for instance?

Benz: It's a trade-off, for sure, because one thing you give up by investing with a single firm is in order to get the lowest possible expense ratios on those funds, you need to stick with the house brand of funds, which you may or may not be comfortable with. So, it's a trade-off. I think, certainly, for people who are getting into their later retirement years, simplifying is a worthy goal. So, even if you have holdings that have worked really well for you, if you have a bunch of onesies where you've got a fund here, a fund there, you may want to think about skinnying down to a single firm or maybe two firms, at most, so that you have fewer oversight responsibilities on an ongoing basis, less paperwork to monitor, and so forth.

Stipp: Christine, a final question for you regarding the money that you withdrew during your bucket portfolio stress test. There were some years, in fact, in the stress test where you didn't change for inflation. How should people think about being dynamic when they're looking at those withdrawals and that can actually help the portfolio's longevity, too?

Benz: It can. So, the principle we used was that if the portfolio had dropped in value during a given year, we did not take an inflation adjustment; but in other years where we had appreciation in the portfolio, we did nudge up our starting value by 3% on an annual basis.

So, I think that that's a really easy way to at least be somewhat sensitive to what's going on to your portfolio. You want to take lower withdrawals in those years when your portfolio is declining; all of the research lines up in terms of being somewhat more flexible. Forgoing that inflation adjustment, that idea was informed by some research that T. Rowe Price did. I think it's a way that people can take at least some action to help improve their portfolio's longevity during those weak markets.

Stipp: Christine, thanks so much for a great presentation. Thanks for answering all of these viewer questions.

Benz: Thank you, Jason.

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