A Conservative ETF Bucket Portfolio for Retirement

Safety and quality are the watchwords of my conservative bucket portfolio, geared toward older retirees with a time horizon of 15 years or fewer.

As such, the portfolio features sizable allocations to cash and short- and intermediate-term bonds, both nominal and inflation-protected. But because 15 years is still a reasonably long time horizon, the portfolio also includes a decent-size equity position, as well as exposure to more economically and credit-sensitive bond holdings such as high-yield and floating-rate funds.

Like the moderate and aggressive versions, this portfolio consists largely 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.

The goal of this and all the Bucket Portfolios is to be as hands-off and low-maintenance as possible, but I have made some adjustments since the portfolios originally appeared. These changes are driven by fundamental considerations and consultation with the senior leaders of Morningstar's team of passive strategies research analysts.

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 retiree 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 a retiree's cash flow needs throughout his or her retirement years. It stakes roughly 30% of assets in stocks and the remainder in cash and bonds. As with all of the portfolios, retirees should use their anticipated cash-flow needs to right-size their own exposures to the different buckets. Older retirees spending only modestly from their portfolios with an eye toward preserving assets for their heirs, for example, would likely want to hold smaller positions in cash and bonds, and more in stocks with growth potential. The allocations to cash and bonds are higher in the Conservative portfolio than in the Aggressive and Moderate ones because older retirees are often spending at a higher rate than younger retirees.

I've divided this portfolio into three components: the cash component (Bucket 1); Bucket 2, consisting of bonds and a high-quality dividend-focused fund; and a long-term growth sleeve (Bucket 3) that holds stocks and higher-risk/higher-reward bond funds. As Bucket 1 (cash) becomes depleted, the retiree 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 1 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 ultrashort-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 3-12

• 13%: Vanguard Short-Term Bond ETF BSV
• 15%: Vanguard Short-Term Inflation-Protected Securities VTIP
• 20%: iShares Core Total U.S. Bond Market IUSB
• 6%: Fidelity Floating Rate High Income FFRHX
• 5%: Vanguard Dividend Appreciation ETF VIG

Vanguard Short-Term Bond and Vanguard Short-Term Inflation-Protected Securities serve as the portfolio's next-line reserves in case Bucket 1 should run dry and income production and/or rebalancing proceeds from Buckets 2 and 3 are insufficient to refill it. iShares Core Total U.S. Bond Market is the portfolio's core fixed-income position, offering broad, inexpensive bond exposure across the credit-quality spectrum.

Bucket 2's stake in a senior-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. I went with an actively managed senior loan fund, mainly because Morningstar doesn't have any medalist ETFs in this category.

Bucket 3: Years 13 and beyond

• 16%: Vanguard Dividend Appreciation ETF VIG
• 7%: Vanguard FTSE All-World ex-US ETF VEU
• 3%: Vanguard High-Yield Corporate Bond VWEHX
• 3%: iShares JPMorgan USD Emerg Markets Bond EMB

The growth engine of the portfolio, Bucket 3 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 fund as well as an actively managed ETF that buys emerging-markets bonds. (Note that I’ve opted for an active fund rather than a passively managed ETF for junk bonds, as an active manager can better manage the credit-quality and liquidity issues that come along with this category.)