Note: The following is part of Morningstar's 2018 Portfolio Tuneup week. A version of this article appeared on Dec. 13, 2017.
The current low-yield environment makes it a challenging time to wring income from a portfolio. Some income-focused investors have ventured further onto the risk spectrum to generate a livable yield; a smaller segment has been sticking with safer sources of income but trying to make do on less.
The Bucket approach to generating living expenses from a portfolio during retirement aims to meet those challenges head on. The basic strategy is that a retiree holds the bulk of her assets in a long-term portfolio that's diversified between stocks and bonds. She then augments it with a cash Bucket that she uses for spending money, and periodically refills that cash Bucket with income distributions, rebalancing proceeds, or both.
This Aggressive Bucket Portfolio is composed of traditional mutual funds. With a roughly 50% equity position and the remainder in cash and bonds, the portfolio is more stock-heavy than other in-retirement portfolios. It's geared toward younger retirees who are comfortable with the higher volatility that accompanies an equity-heavy mix.
The central idea of the Bucket strategy, as envisioned by financial-planning guru Harold Evensky, is to include a cash Bucket to cover near-term cash needs. Over time, the cash Bucket will weigh on the portfolio's performance, as longer-term assets (stocks and bonds) will tend to generate better returns. The big benefit of the cash cushion, however, is that it provides peace of mind for a retiree to know that assets for pending expenses are safely segregated from the more volatile assets in the portfolio. Even in a scenario in which the stock portion of the portfolio dropped precipitously, the retiree could spend the cash in Bucket 1 and even move into the portfolio's next-line reserves--short-term bonds--without having to sell any stocks at a low ebb.
This particular portfolio is geared toward retirees who expect to live 25 or more years in retirement. As with all of my portfolios, its goal isn't to generate the best returns of any retirement portfolio on record, but rather to help retirees and pre-retirees visualize what a long-term, strategic total-return portfolio would look like. Thus, a newly retired investor could follow the basic Bucket concept without completely upending existing favorite holdings.
The portfolio includes three Buckets geared toward the near, intermediate, and long term.
Bucket 1: Years 1-2
- 8%: Cash (certificates of deposit, money market accounts, and so on)
The goal of this portion of the portfolio is to provide money for cash needs in years one and two of retirement, so we're not taking any risks with it. The yields on true cash instruments are currently comparable with those of short-term investments that don't ensure principal stability, so there's no sense in going with something that's not FDIC-insured.
An investor's own cash Bucket, and in turn the allocations to the other two Buckets, will depend on his or her portfolio spending rate. This article discusses how to customize your portfolio's asset allocation based on your anticipated spending level.
Bucket 2: Years 3-10
- 8%: Fidelity Short-Term Bond (FSHBX)
- 10%: Harbor Bond HABDX
- 7%: Vanguard Shirt-Term Inflation-Protected Securities (VTAPX)
- 10%: Vanguard Wellesley Income (VWIAX)
This portion of the portfolio is designed to deliver slightly more income than Bucket 1, as well as a dash of inflation protection and capital appreciation. The Fidelity Short-Term Bond fund is there if, in a worst-case scenario, Bucket 1 were depleted and rebalancing proceeds and/or income from the portfolio were insufficient to meet living expenses.
Despite the prospective headwinds of rising interest rates, I'm still comfortable with the fact that this portion of the portfolio is anchored in bonds. The linchpin bond holding, Harbor Bond, may suffer some short-term volatility if and when rates rise again; indeed, it lost 3% when bond yields spiked during the summer of 2013. Over time, however, the fund should be able to make up short-term principal losses by swapping into higher-yielding bonds as they become available.
Because this portion of the portfolio has a longer time horizon but is focused on fixed-income investments, inflation is more of a concern. Thus, I've included a fund that invests in Treasury Inflation-Protected Securities, which adjust their principal values upward to keep pace with the Consumer Price Index. The short-term Vanguard fund delivers the desired inflation protection without the extreme rate sensitivity that accompanies longer-duration TIPS.
Bucket 3: Years 11 and Beyond
- 10%: Vanguard Total Stock Market Index (VTSAX)
- 24%: Vanguard Dividend Appreciation (VDADX)
- 15%: Harbor International HAINX
- 8%: Loomis Sayles Bond LSBDX
Due to an anchor position in Vanguard Dividend Appreciation, which focuses on companies with a history of growing their dividends, the portfolio has a high-quality tilt that's appropriate for a retirement portfolio. (Note that the original version of this portfolio included a position in Vanguard Dividend Growth (VDIGX), but that fund closed in late July 2016; we supplanted it with this like-minded index fund.) A smaller position in Vanguard Total Stock Market supplies exposure to sectors that tend to be underweight in the Vanguard fund, such as technology.
I'm also comfortable with Harbor International despite its recently weak performance and a downgrade in its analyst rating from Gold to Silver. I believe its proven management team and their long-term focus should hold it in good stead going forward. Investors who aren't comfortable with the manager risk and the possibility for stock and sector positioning to go awry could reasonably buy a total international index fund.
The biggest change with this portfolio (and all of the retirement Bucket portfolios) is that I've jettisoned the commodity position that had been in the portfolio since inception, Harbor Commodity Real Return Strategy HACMX. Harbor is liquidating the fund, though PIMCO Commodity Real Return (PCRIX) remains open.
As a contrarian, I was pained to cut an asset class that has underperformed for as long as commodities have. But my reasons for not replacing the fund with another commodities option were twofold. First, there are few reasonably priced commodities options for retail mutual fund investors. Morningstar only confers Medalist ratings upon two commodity funds, the aforementioned PIMCO Commodity Real Return and PIMCO CommoditiesPLUS Strategy (PCLIX). While the institutional share classes charge a not unreasonable 0.74% per year, neither fund is accessible at a reasonable price without a load through fund supermarkets. (The D shares that are available levy a 1.19% expense ratio, setting up a high hurdle.)
In addition, the asset allocations of the model portfolios loosely mirror those of Morningstar's Lifetime Allocation Indexes, which reduced their commodities weightings last year. Morningstar senior portfolio manager Brian Huckstep detailed the rationale in this video, noting that a phenomenon called negative roll yield has served as an additional, unavoidable toll on funds that buy commodities futures. The indexes didn't cut commodities altogether--most hold roughly 2% positions. But my goal for these portfolios is to limit complexity, and maintaining a 2% position in a niche asset class doesn't jibe with that goal. I steered the 5% of assets that had previously been earmarked for commodities into Vanguard Short-Term Inflation-Protected Securities (an additional 3% of assets) and Harbor International (an extra 2% of assets) to bring their weightings more closely in line with the indexes.
Christine Benz does not own shares in any of the securities mentioned above. Find out about Morningstar's editorial policies.