Note: The following is part of Morningstar's 2018 Portfolio Tuneup week. A version of this article appeared on Dec. 13, 2017.
Many retired investors are comfortable embracing a healthy equity stake in their portfolios. That's a sensible tack for retirees with longer time horizons, those with generous income streams from nonportfolio sources like pensions, and those who know that they want to leave money behind for their children, other loved ones, or charity.
This Conservative Bucket Portfolio has a more modest goal: preserving purchasing power and delivering living expenses for the retiree who has an approximately 15-year time horizon (that is, life expectancy). This portfolio does stake more than 30% in equities, but it also holds more than 50% of its assets in bonds and another 12% in cash.
Let Time Horizon Lead the Way
The main idea behind the Bucket approach is to segment the portfolio by the spending time horizon: Assets that will be tapped sooner are parked in short-term holdings, and longer-term monies are stashed in higher-returning, higher-volatility asset types, mainly stocks.
To construct a Bucket portfolio, the retiree starts with anticipated income needs for a given year, then subtracts certain sources of income such as Social Security and a pension. What's left over is the amount of cash flow that the portfolio will need to supply each year (in other words, the desired withdrawal amount, including income, capital gains, and outright withdrawals). In the case of the conservative portfolio, one to two years' worth of living expenses (those not covered by Social Security, and so on) are housed in cash instruments (Bucket 1), and another 10 years' worth of living expenses are housed in bonds (Bucket 2). The remainder of the portfolio is invested in stocks and a high-risk bond fund. Income and rebalancing proceeds from Buckets 2 and 3 are used to replenish Bucket 1 as it becomes depleted.
As noted earlier, the conservative portfolio's focus is on capital/purchasing power preservation and income production, so it stakes roughly 70% in bonds and cash. That will likely strike many retirees and pre-retirees as overly bond-heavy. After all, starting yields are minuscule, and the next few decades are unlikely to be as kind to bonds as the previous three were. Yields will go up, but they'll hurt bond prices in the process.
In recognition of that fact, I've generally aimed to steer the portfolio away from the most interest-rate-sensitive bonds. Moreover, as with the Moderate and Aggressive portfolios, the specific parameters of the Conservative portfolio can be altered to suit a retiree's own goals and preferences. For example, a more risk-tolerant, growth-oriented retiree may choose to hold just one year of cash in Bucket 1 while also shrinking the number of years' worth of assets in bonds, thereby enlarging the equity stake as a percentage of assets.
And though I've supplied specific fund recommendations in my model portfolios, a retiree needn't reinvent the wheel to put the Bucket approach to work: Many of the key ingredients likely already appear in well-diversified retiree and pre-retiree portfolios. A total stock market index fund or a portfolio of individual dividend-paying equities could stand in for Vanguard Dividend Appreciation (VDADX), for example. Meanwhile, a retiree in search of simplification could use an all-in-one-type investment such as T. Rowe Price Spectrum Income (RPSIX) to supplant the individual holdings that make up bucket two.
The portfolio includes three Buckets, one each for short-, intermediate-, and longer-term spending needs.
Bucket 1: Years 1-2
- 12%: Cash (certificates of deposit, money market accounts, and so on)
This portion of the portfolio is geared toward meeting near-term spending needs. Because of this role, it sticks with true cash instruments, as noncash alternatives like ultrashort bond funds have lower yields and more risk than CDs right now. Retirees should use their own expected portfolio withdrawals to back into an appropriate cash target, as discussed here.
Bucket 2: Years 3-10
- 12%: Fidelity Short-Term Bond (FSHBX)
- 5%: Fidelity Floating Rate High Income (FFRHX)
- 20%: Harbor Bond (HABDX)
- 11%: Vanguard Short-Term Inflation-Protected Securities (VTAPX)
- 5%: Vanguard Wellesley Income (VWIAX)
Bucket 2 is designed, in aggregate, to preserve purchasing power and deliver income with a dash of capital appreciation. Fidelity Short-Term Bond serves as the portfolio's next-line reserves in case Bucket 1 were depleted and bond and dividend income and/or rebalancing proceeds were insufficient to refill it. Fidelity Floating Rate High Income, one of the most conservative bank-loan vehicles, provides both a cushion against rising bond yields (bank-loan yields adjust upward along with lending rates) and a measure of inflation protection (yields are often heading up at the same time inflation is).
Harbor Bond is the portfolio's core fixed-income holding; the PIMCO-managed bond fund has a good deal of flexibility to adjust duration (a measure of interest-rate sensitivity), invest in foreign bonds, and range across bond-market sectors. I also used Vanguard Short-Term Inflation-Protected Securities to provide a measure of inflation protection; it owns bonds whose principal values adjust upward to keep pace with the Consumer Price Index, but it's less sensitive to interest-rate-related volatility than intermediate- and long-term Treasury Inflation-Protected Securities vehicles. Finally, Bucket 2 includes the conservatively allocated Vanguard Wellesley Income, which is anchored in fixed-income investments but also holds roughly 40% in stocks, both U.S. and foreign.
Bucket 3: Years 11 and Beyond
- 23%: Vanguard Dividend Appreciation (VDADX)
- 7%: Harbor International (HIINX)
- 5%: Loomis Sayles Bond (LSBRX)
As the long-term portion of the portfolio, Bucket 3 holds primarily stocks. Its anchor holding, as in the Aggressive and Moderate portfolios, is Vanguard Dividend Appreciation, an ultracheap equity fund that skews toward high-quality stocks. (The original version of this portfolio featured Vanguard Dividend Growth (VDIGX) in lieu of Vanguard Dividend Appreciation, but the former closed to new investors in July 2016.) I've also included a healthy stake in Harbor International. The equity portion of the portfolio includes limited exposure to small- and mid-cap stocks; investors who would like more exposure to that area might consider a fund such as Vanguard Small Cap Index (NAESX) or Royce Special Equity (RYSEX).
In addition to two equity holdings, the portfolio also includes a position in Loomis Sayles Bond, which supplies exposure to more aggressive bond types (and even stocks) that are not well-represented in Bucket 2.
The biggest recent change to the portfolio is the elimination of Harbor Commodity Real Return HACMX, which the firm is liquidating. I decided to not replace it with another commodities option for a couple of reasons.
Yes, the fund has performed poorly, but that wasn't a major influence in my decision to cut it. (If anything, its poor performance made me tempted to hang on, as poor-performing categories inevitably have their day.) Instead, there are simply few good alternatives for no-load, retail investors. Both PIMCO Commodity Real Return (PCRIX) and PIMCO CommoditiesPLUS Strategy (PCLIX) earn medalist ratings currently, but their retail versions are pricey.
In addition, I use Morningstar's Lifetime Allocation Indexes to help shape the portfolios' asset-class exposures. Those indexes started to downplay commodities in 2016, as detailed in this video, due in part to a phenomenon called negative roll yield. 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. That brings the portfolio's weightings in inflation-protected bonds more closely in line with the indexes' TIPS weightings. Moreover, one of the original goal of the commodities exposure was to provide inflation protection, and TIPS fulfill that role, too.
Christine Benz does not own shares in any of the securities mentioned above. Find out about Morningstar's editorial policies.