A Conservative 3-Bucket ETF Portfolio for Retirees

Investors who are still in the accumulation phase, as well as younger retirees with long time horizons, absolutely should have a sizable share of their portfolios in stocks. By being too conservative, they heighten the risk of falling short later in retirement.

But retirees with shorter time horizons may need to play it more safely because encountering a bear market could deal their portfolios a blow from which they may not recover. For them, the name of the game is protecting purchasing power during their life spans, with a secondary emphasis on capital growth.

That's the aim of my Conservative bucket portfolio, geared toward older retirees with a time horizon of 15 years or fewer. Stocks are represented here, as are more economically and credit-sensitive bond holdings such as high-yield and floating-rate funds. But the overall emphasis is on safety and quality, with sizable allocations to cash and short- and intermediate-term bonds, both nominal and inflation-protected.

Like the Moderate and Aggressive versions, this portfolio consists entirely of exchange-traded funds. The fact that most of these offerings are passively managed helps keep the overall portfolio's cost load down, which is particularly important given that the portfolio's absolute rate of return is apt to be modest. And because broad-market ETFs are well diversified, it's easy for an investor to reduce the complexity of the portfolio--a worthy goal for those in their later retirement years. Finally, ETFs can be effective holdings in taxable accounts, as equity ETFs (and traditional index mutual funds, too) will tend to dish out limited capital gains distributions. (There's no real tax benefit associated with holding a bond ETF instead of a bond mutual fund, however.)

Bucket Basics My conservative ETF bucket portfolio uses the same general framework and assumptions as the Conservative portfolio consisting of traditional mutual funds. It's geared toward a retired couple with a roughly 15-year time horizon (that is, life expectancy) and a fairly low risk capacity. The aim of the portfolio is to meet their cash flow needs throughout their retirement years. It stakes roughly 30% of assets in stocks and the remainder in cash, bonds, and a small slice of commodities.

Because the couple's time horizon is shorter than the 30 years that underpins the 4% rule, they're using a higher withdrawal rate of 5.5%. That means they will withdraw 5.5% in the first year, then inflation-adjust that amount in each year thereafter.

As with the other portfolios, I've divided this portfolio into three components: the cash component (bucket one); bucket two, consisting of bonds and a high-quality dividend-focused fund; and a long-term growth sleeve (bucket three) that holds stocks and higher-risk/higher-reward bond funds. As bucket one (cash) becomes depleted, the couple can refill it using income from their dividend-producing equities and bonds, rebalancing proceeds, or a combination of the two.

Bucket 1: Years 1 and 2

• 12%: Cash (certificates of deposit, money market accounts, checking and savings accounts, and so on)

The goal of bucket one is capital preservation, so it's stashed in cash instruments. Because inflation will bite into the purchasing power of any dollars held here, this portion of the portfolio should max out at two years' worth of living expenses to help minimize its opportunity costs. Noncash, nonguaranteed alternatives such as ultra-short-term bond funds may work in this portion of the portfolio if yields rise a bit, but right now they're a poor substitute for true cash.

Bucket 2: Years 3-10

• 10%: Vanguard Short-Term Bond ETF BSV
• 5%: PowerShares Senior Loan Portfolio BKLN

Vanguard Short-Term Bond and Vanguard Short-Term Inflation-Protected Securities serve as the portfolio's next-line reserves in case bucket one should run dry and income production and/or rebalancing proceeds from buckets two and three are insufficient to refill it. As with the other portfolios, PIMCO Total Return ETF remains the core fixed-income position here, owing to its latitude to adjust duration and graze among various fixed-income sectors.

Bucket two's stake in a bank-loan offering, as well as a small position in Vanguard Dividend Appreciation, supply this part of the portfolio with sensitivity to the economic cycle and the equity market.

Bucket 3: Years 11 and beyond

• 23%: Vanguard Dividend Appreciation ETF
• 5%: PowerShares DB Commodity Index Tracking DBC

The growth engine of the portfolio, bucket three is anchored with two core equity funds, one domestic and the other focused on foreign stocks. I've used Vanguard Dividend Appreciation to supply a tilt toward higher-quality firms and reduce overall volatility, but one could use a total U.S. stock market index fund instead.

This portion of the portfolio also features noncore fixed-income positions--small stakes in a junk-bond ETF as well as an actively managed ETF that buys emerging-markets bonds denominated in local currencies. The latter fund has struggled along with most emerging-markets vehicles during the past year, but it's a small position and still has merit as a diversifier. And though the equity holdings in bucket three give it a good shot at outpacing inflation over time, PowerShares' commodity ETF provides an additional layer of inflation protection.