An Aggressive ETF Bucket Portfolio for Retirement

The past few decades have brought huge challenges for retirees and pre-retirees: two market crashes, the ebbing away of pension plans, and dramatically declining interest rates.

The bucket approach to retirement planning doesn't solve all of those problems. But as a total-return strategy, it helps retirees build a diversified portfolio that isn't overly dependent on whatever the interest-rate gods are serving up at any given point in time. In lieu of focusing strictly on income-rich securities, retirees using the bucket approach set aside a baseline of cash for near-term living expenses. Before that bucket runs dry, they can refill it with dividend and income distributions and/or rebalancing proceeds.

The years 2008 and 2009, during the financial crisis, provide a useful illustration of how the bucket strategy can help retirees deal with challenging conditions. Because bucket one holds enough cash to cover one to two years' worth of living expenses, the retiree wouldn't have to sell stocks or risky bond types, all of which suffered big losses in 2008, at a low ebb. The cash cushion would also allow income-focused investors to regroup as bond yields dropped dramatically lower and many financial-services firms slashed their dividends.

I've created a number of in-retirement model "bucket" portfolios, employing both traditional mutual funds and exchange-traded funds. To be sure, there's a lot to like about ETFs for retirees. First, the good ones are fairly cheap. And as retirees shift more and more of their portfolios into low-returning asset classes, such as cash and bonds, keeping expenses down is a great way to boost take-home returns. Broad-based ETFs (and index funds) also provide a lot of diversification in a single shot, and with no managers to monitor, retirees will have less day-to-day portfolio oversight. Finally, equity ETFs and index funds can be highly tax-efficient, an attractive feature for retirees with sizable taxable account balances. (Bond ETFs will receive similar tax treatment as bond mutual funds; there's no tax benefit to the ETF wrapper for securities that kick off ordinary income.)

Bucket Basics My aggressive ETF bucket portfolio uses the same general framework and assumptions as the aggressive mutual fund portfolio. It assumes a couple with a 25-year time horizon (or longer) and a fairly high risk capacity. It also assumes they're using the standard 4% approach to portfolio withdrawals, meaning they'll withdraw 4% of their original balance in year one of their retirement and inflation-adjust that sum in subsequent years. As bucket one is depleted, they will refill it using dividend and income distributions, rebalancing proceeds, or both.

As with the mutual fund portfolios, I've employed three buckets here: bucket one, for near-term living expenses; bucket two, holding securities with an intermediate-term time horizon in mind, primarily bonds; and bucket three, holding the portfolio's longest-term growth assets.

Bucket 1: Years 1-2

• 8%: Cash (certificates of deposit, money market accounts and funds, and so on)

As the liquidity sleeve of the portfolio, the focus of bucket one is stability with a modest dose of income. Yields on many cash alternatives, such as ultrashort bond funds, are currently lower than what you'd earn on true cash instruments. Meanwhile, such investment types don't guarantee--either implicitly or explicitly--that your principal value won't fluctuate. Thus, they're a poor substitute for cash right now, even though they may look more attractive when short-term yields eventually trend up.

Bucket 2: Years 3-10

• 8% Vanguard Short-Term Bond ETF BSV

PIMCO Total Return is bucket two's core fixed-income position, just as Harbor Bond (a near-clone of

PIMCO Total Return PTTRX) is the anchor fixed-income holding in the mutual fund bucket portfolios. So-called "core-plus" products like these, which my colleague Eric Jacobson outlined here, they have the latitude to venture beyond the securities in the Barclays U.S. Aggregate Bond Index and take small positions in emerging-markets and high-yield bonds. They can also position duration (a measure of interest-rate sensitivity) differently from the index.

This portion of the portfolio also holds a stake in a plain-vanilla short-term bond index fund to serve as next-line reserves should bucket one become depleted and income and rebalancing proceeds are insufficient to refill it. Meanwhile, Vanguard Short-Term Inflation-Protected Securities promises less interest-rate-related volatility than core TIPS funds, as well as some insulation against unexpected inflationary pressures.

At the tail-end of bucket two is a position in Vanguard Dividend Appreciation, which is also the main equity holding in bucket three.

Bucket 3: Years 11 and Beyond

• 25%: Vanguard Dividend Appreciation Index ETF

Bucket three is the growth engine of the portfolio and also has the longest anticipated holding period. Therefore, it features heavy equity exposure as well as smaller stakes in volatile, credit-sensitive bond types and commodities.

Vanguard Dividend Appreciation is the portfolio's largest position. Although its dividend is just over 2%, it's not too much higher than the broad market's. But the key attraction here is a focus on quality: The fund focuses on highly profitable firms with histories of raising dividends. That makes it an appropriate anchor holding for investors at any life stage, but its below-average volatility makes it especially appealing for retirees. The portfolio also includes U.S. and foreign-markets index exposure, to bring its costs down and fold in sectors that aren't well represented in Vanguard Dividend Appreciation, such as financials and technology.

Whereas the mutual fund portfolios include a stake in

Loomis Sayles Bond LSBDX in bucket three, the ETF portfolios take a piecemeal approach to riskier bond-market sectors, taking small positions in a junk-bond and local-currency-denominated emerging-markets bond fund. I prefer active management in some of these areas--especially junk bonds--but these ETFs should serve as reasonable aggressive kickers for the portfolio. A commodity-index-tracking ETF provides additional inflation protection.