Tax-Efficient 'Bucket' Retirement Portfolios for Fidelity Investors

Judging from the many comments and emails that followed, my recent article featuring bucket portfolios composed entirely of Fidelity funds struck a chord.

A handful of readers said that portfolios composed of funds from a single shop are unnecessary in an age of fund supermarkets, which give investors the ability to buy anything from Metropolitan West to Fidelity to Matthews. (Point taken.) Other observers said they found the article too laudatory toward Fidelity. ("When are you doing Vanguard portfolios?" was a common refrain. Answer: They're coming.)

Meanwhile, other readers said that, as longtime Fidelity investors, participants in Fidelity-managed retirement plans, or retirees interested in streamlining with a single fund shop, they found the article useful in helping them strategize about and benchmark their own retirement portfolios.

My initial Fidelity bucket portfolios--conservative, moderate, and aggressive--were geared toward investors in tax-deferred accounts like IRAs. With healthy allocations to bonds, including stakes in tax-unfriendly categories like TIPS and commodities, these portfolios are not going to be particularly tax-efficient over time. Therefore, they are a better fit for accounts where investors are not paying taxes on their regular distributions.

But many retirees hold additional assets in taxable accounts, and prioritizing tax efficiency there can help plump their take-home returns. As it turns out, Fidelity's lineup lends itself well to managing a tax-efficient portfolio of cash, bonds, and stocks; several of its best funds, in fact, are also quite tax-friendly. The firm's municipal-bond lineup has long been one of Morningstar's favorites, featuring reasonable costs, experienced management, and strong analytics. And while Fidelity shuttered its tax-managed stock fund in 2012, the firm's equity-index offerings are reasonably tax-efficient alternatives with exceptionally low costs.

Aiming for the Buckets As envisioned by financial-planning guru Harold Evensky, the bucket approach centers on a practical and intuitive idea. If retirees know that they have their near-term income needs set aside in cash, they can more readily tolerate the fluctuations that inevitably accompany longer-term assets.

Evensky's basic bucket approach included a cash bucket to help meet near-term living expenses alongside a stock/bond bucket built for income and growth. In my bucket portfolios, I've featured three buckets: bucket one, holding cash for near-term income needs (years one and two of retirement); bucket two, consisting of bonds and enough assets for the next eight years of retirement; and bucket three, primarily stocks and other growth assets, geared for years 11 and beyond of retirement.

To help set the asset allocations for buckets two and three of the portfolios, I've used Morningstar's Lifetime Allocation Indexes to help guide the way. Because it's difficult to add value with tactical asset allocation, these portfolios are meant to be strategic--that is, bought, held, and rebalanced. I'll periodically review them and report on their progress, but I expect to make changes only when there's a fundamental negative development at one of the holdings. The goal of these bucket portfolios is to illustrate sound portfolio-management practices during retirement, not to blow the doors off in terms of performance.

To populate the portfolios, I've relied heavily on

, as well as the insights of Morningstar's lead Fidelity analyst, Katie Reichart. Because most retirees would rather not have to keep an eye on many moving parts in their portfolios, I favored investments that provide significant exposure to a given asset class in a single shot. I also prioritized investments that have been tax-efficient in the past and are likely to be tax-friendly going forward. Because reliably tax-efficient investments are few and far between, these portfolios are more compact than the previous Fidelity bucket portfolios.

Aggressive Bucket Portfolio Anticipated Time Horizon: 25 or more years

Bucket 1: Years 1-2 8%: Cash (certificates of deposit, money market accounts, and so forth; percentages will vary based on amount of assets and spending rate)

The goal of this portion of the portfolio is to provide money for cash needs in years one and two of retirement. The size of this bucket--in both percentage and dollar terms--will vary depending on the retiree's income needs and total assets. For example, a retiree with a $1 million portfolio who's withdrawing just $30,000 a year from her portfolio would have only 6% ($60,000) of her portfolio in cash (her $30,000 annual living expenses times two years). Retired investors will also want to keep withdrawal sequencing in mind when deciding how much cash to keep on hand. If they expect withdrawals from the taxable portion of the portfolio to be relatively modest, they'd want to reduce bucket one accordingly.

Bucket 2: Years 3-10


10%:

27%:

This portion of the portfolio steps out on the risk spectrum from bucket one--but not too far. The Gold-rated Fidelity Limited Term Municipal Income serves as next-line reserves in case bucket one (cash) runs dry, the yields from buckets two and three are insufficient to refill it, and there are no rebalancing opportunities. However, it's not a money market substitute: Senior analyst Elizabeth Foos points out that its duration--which lead manager Mark Sommer and his team keep roughly in line with the Barclays 1-6 Municipal Bond Index--tends to be longer than other muni-national short-term funds. However, she notes that the fund's focus on high-quality bonds, an experienced management team backed by strong analytics, and reasonable costs give it a strong chance of outperforming its peers over time.

The bulk of bucket two is parked in another Gold-rated Fidelity muni fund, Fidelity Intermediate Municipal Income. Sommer also heads up the team in charge here and tends to run the fund in a similar, risk-conscious style. Like the Limited Term fund, its benchmark's duration is a touch longer than its peer group's, but a high-quality portfolio has helped protect on the downside. The flip side is that the fund tends not to shoot out the lights in big muni rallies, but that's an acceptable trade-off given that the goals of bucket two are a modest level of income along with principal stability.

Bucket 3: Years 11 and Beyond


40%:

15% Fidelity Spartan Global ex-US Index Advantage FSGDX

In the interest of simplicity, I used two broadly diversified equity funds for this portion of the portfolio--a larger position in a total U.S. market tracker and a smaller stake in a fund that tracks the MSCI All Country World ex-US Index. Both feature low costs and broad diversification.

Investors who would like to exert a higher level of control over their portfolios' suballocations could reasonably employ a few more funds with this portion of the portfolio. For example, buying

Moderate Bucket Portfolio Anticipated Time Horizon: 20 years This portfolio contains the same holdings as the aggressive Fidelity portfolio, differing only in its allocations to them. Its cash stake is the same, but because it's geared toward retirees with shorter time horizons, it includes larger positions in high-quality short- and intermediate-term bonds and smaller positions in equities.

Bucket 1: Years 1-2 8%: Cash (certificates of deposit, money market accounts, and so forth; percentages will vary based on amount of assets and spending rate)

Bucket 2: Years 3-10 12%: Fidelity Limited Term Municipal Income 35%: Fidelity Intermediate Municipal Income

Bucket 3: Years 11 and Beyond 35%: Fidelity Spartan Total Market Index Advantage 10% Fidelity Spartan Global ex-US Index Advantage

Conservative Bucket Portfolio Anticipated Time Horizon: 15 years In contrast with the aggressive and moderate portfolios, both of which emphasize growth to varying extents, this portfolio is geared toward older retirees with shorter time horizons/life expectancies. As such, its focus is on preserving purchasing power and funding living expenses; capital appreciation is secondary. Because its growth prospects are relatively low, it would not be appropriate for younger retirees unless they are extremely risk-averse and--more importantly--have more than enough money to last throughout their retirement years.

Bucket 1: Years 1-2 8%: Cash (certificates of deposit, money market accounts, and so forth; percentages will vary based on amount of assets and spending rate)

Bucket 2: Years 3-10 15%: Fidelity Limited Term Municipal Income 37%: Fidelity Intermediate Municipal Income

Bucket 3: Years 11 and Beyond 30%: Fidelity Spartan Total Market Index Advantage 10% Fidelity Spartan Global ex-US Index Advantage