How Our Schwab Model Bucket Portfolios Have Performed

Gone are the days when managing a portfolio during retirement meant hunkering down in safe, income-producing securities. Today's retiree portfolios absolutely should prioritize income production, but they also need the growth potential that comes along with holding stocks. After all, even yields that are generous by today's standards--3% or more--may not be able to keep pace with inflation over the long haul. And retirement may be a 25- to 30-year proposition for many: With such a long time horizon, retirees should be able to withstand the volatility that inevitably accompanies stocks.

That's why all of my Model Bucket Portfolios--geared to people who are already retired--contain substantial positions in stocks. Thanks to those hefty equity positions, they've gotten a performance boost during the past three years of their existence as stocks have rallied.

Now that the portfolios have roughly three years' worth of history, it's a good time to check up on what's been working for them and what hasn't been. I also wanted to conduct a thorough review of the holdings. Several of the positions in the original Schwab Bucket Portfolios have seen analyst ratings downgrades or experienced management changes. As a result, I've swapped in new holdings in place of the old ones; in the case of commodities, I cut the position altogether. Because Schwab supermarket investors aren't wedded to the "house brand" of mutual funds, they have a surfeit of options from which to choose. And because these Bucket Portfolios are geared toward tax-deferred accounts like IRAs, making changes won't entail tax costs.

Bucket Basics Before we delve into the specifics of the portfolios, it's worth reviewing the basics of the Bucket strategy. In a nutshell, a Bucket portfolio is organized by a retiree's spending horizon. Assets that the retiree expects to spend within the next few years go into cash, the only asset class where principal is guaranteed to remain stable. Assets for the next several years can go into bonds, which aren't guaranteed but have higher return potential than cash. And assets that a retiree won't have to touch for another decade or so can go into stocks and other higher-risk/higher-return asset classes. While stocks have been unsteady for time horizons of less than 10 years, they've been quite reliable over 10-year time horizons or longer.

That's not to say that a retiree has to spend through the buckets in exactly that sequence--cash first, followed by bonds, followed by stocks. Right now, for example, retirees' appreciated equity holdings would appear to be a particularly sensible way to extract cash reserves from a portfolio. Not only will doing see tee up spending money for the next few years, but it will also reduce the portfolio's volatility level.

As with the other portfolios, I used Morningstar's Lifetime Allocation Indexes to shape the portfolios' asset-class exposures. However, a retiree should use her own expected portfolio withdrawals to determine the allocations to each of the buckets. For example, a retiree with a $1 million portfolio who's withdrawing just $30,000 per year of her portfolio could allocate two years' worth of expenditures ($60,000, or 6% of her total portfolio) to cash/Bucket 1, eight years' worth of expenditures ($240,000, or 24% of her total portfolio) to bonds/Bucket 2, and the remainder to stocks. In other words, here allocation to conservative investments would be even smaller than what's depicted in my Aggressive portfolio.

For security selection, I married Morningstar's Medalist-rated funds with Schwab's lineup of no-load, no-transaction-fee funds. Schwab fields a strong lineup of index funds and ETFs, which are well represented here and in the tax-efficient Schwab portfolios, but its supermarket lineup also includes plenty of solid funds run by outside managers. The Schwab platform features no-load, no-transaction-fee share classes of funds that had historically been broker-sold--for example, American Funds and BlackRock.

Aggressive Bucket Portfolio

Bucket 1: Years 1-2 8%: Cash (money market funds and accounts, CDs, checking and savings accounts, and so forth; specific percentages will vary based on the amount of assets and the retiree's spending rate)

Bucket 2: Years 3-10

10%:

7%:

15%:

Bucket 3: Years 11 and Beyond

20%:

15%:

5%:

10%:

5%: Credit Suisse Commodity Return Strategy CRSAX

5%:

Performance 3-Year Annualized Return: 7.05% The portfolio's U.S. equity holdings contributed the most to returns over the past three years. Schwab's ultralow-cost, Gold-rated Total Stock Market Index generated a 15% annualized return over the past three years, the highest of any holding, followed closely by Oakmark Fund. Diamond Hill Small Mid Cap generated a 10% annualized return--impressive in absolute terms but underwhelming relative to its mid-cap value peers. And while foreign stocks as a group underperformed U.S., especially when foreign-currency adjustments were taken into account, Harbor International struggled relative to its peers, too. The fund recently underwent a management change, prompting me to drop it from the portfolios. (See changes below.)

Loomis Sayles Bond generated a respectable 4.4% gain, and one would have expected it to deliver strong results in the type of "risk-on" bond market that has prevailed over the past three years. However, the portfolio's other fixed-income positions did little more than hold their ground during the period, and were close to dead money on an inflation-adjusted basis. Credit Suisse Commodity Return Strategy was the portfolio's only losing position over the past three years.

Changes The holdings in the portfolio have experienced a flurry of analyst downgrades and manager changes over the past few years, prompting significant changes to the portfolios themselves.

While I retained Schwab Total Stock Market Index and Oakmark Fund as core equity holdings, Diamond Hill Small Mid Cap's closure to new investors prompted me to steer its 5% allocation into the Schwab fund, which itself includes decent (albeit more diffuse) exposure to small- and mid-cap stocks. Diamond Hill remains highly rated by Morningstar's analyst team, so investors who already own it have good reason to hang on. But the portfolios are designed to be investable, so all of the holdings need to be open to new investors.

In keeping with my core bucket portfolios, I replaced Harbor International with American Funds International Growth & Income. The Harbor fund has seen significant shareholder redemptions and recently underwent a manager change; Harbor has also indicated that the fund will make an enormous capital gains distribution later this year. American Funds International Growth and Income, meanwhile, features a sensible focus on reasonably priced dividend payers overseas, a seasoned management team, and a fair expense ratio. Ample emerging markets exposure means it won't be immune to volatility, but it has managed with the prudence that has long characterized the American Funds lineup.

Analyst rating downgrades also prompted me to make changes to the fixed-income lineup. While Metropolitan West Total Return Bond remains the core bond position, both USAA Short-Term Bond and BlackRock Inflation Protected Bond have both experienced manager changes and ratings downgrades. As a result, I replaced them with bond funds with more certain prospects. Baird Short-Term Bond, a Silver-rated offering run by an extremely seasoned team, fills the small-cap slot; Morningstar's analyst team considers it one of their highest-conviction short-term bond fund picks For exposure to inflation-protected bonds, I swapped in Schwab's Treasury Inflation-Protected Securities, which features an ultracheap 0.05% expense ratio. As Miriam Sjoblom notes in this article, active TIPS managers have had a difficult time adding value relative to inexpensive index-tracking products.

Finally, I dropped Credit Suisse Commodity Return Strategy, to align with the Lifetime Allocation Indexes' lower weightings in commodities. While the indexes haven't excised commodities altogether, they have taken the positions down to the low single digits, in light of the negative roll-yield effects that have bedeviled commodities futures products. My bias is to run these portfolios with as few holdings as are needed to deliver diversification, so I decided to excise commodities altogether instead of maintaining small positions. I steered the 5% of assets that had been earmarked for commodities into American Funds International Growth and Income.

Moderate Bucket Portfolio

Bucket 1: Years 1-2 10%: Cash (money market funds and accounts, CDs, checking and savings accounts, and so forth; specific percentages will vary based on the amount of assets and the retiree's spending rate)

Bucket 2: Years 3-10 10%: USAA Short-Term Bond 10%: BlackRock Inflation-Protected Bond 20%: Metropolitan West Total Return Bond

Bucket 3: Years 11 and Beyond 15%: Oakmark Fund 10%: Schwab Total Stock Market 5%: Diamond Hill Small Mid Cap 10%: Harbor International 5%: Credit Suisse Commodity Return Strategy 5%: Loomis Sayles Bond

Performance 3-Year Annualized Return: 5.63% Because of its higher bond stake and lower equity position, this portfolio's return was a bit below the Aggressive portfolio's over the past three years. As with the Aggressive portfolio, the pure large-cap equity holdings (especially Schwab Total Stock Market Index) contributed the most to performance over the trailing three-year period. And while Loomis Sayles Bond delivered robust gains--in absolute and relative terms--the other bond holdings merely limped along. The portfolio's commodity position was the sole losing holding.

Changes I incorporated the same changes noted above into the Moderate portfolio. Specifically, I supplanted Harbor International with American Funds International Growth and Income, and steered Diamond Hill Small Mid Cap's weighting into Schwab Total Stock Market Index. On the fixed-income side, I replaced USAA Short-Term Bond and BlackRock Inflation Protected Bond with Baird Short-Term Bond and Schwab Inflation-Protected Securities, respectively. I excised Credit Suisse Commodity Return Strategy and steered the proceeds into American Funds International Growth and Income.

Conservative Bucket Portfolio

Bucket 1: Years 1-2 12%: Cash (money market funds and accounts, CDs, checking and savings accounts, and so forth; specific percentages will vary based on the amount of assets and the retiree's spending rate)

Bucket 2: Years 3-10 13%: USAA Short-Term Bond 10%: BlackRock Inflation-Protected Bond 25%: Metropolitan West Total Return Bond

Bucket 3: Years 11 and Beyond 10%: Oakmark Fund 10%: Schwab Total Stock Market 10%: Harbor International 5%: Credit Suisse Commodity Return Strategy 5%: Loomis Sayles Bond

Performance 3-Year Annualized Return: 4.50% With just 30% of assets allocated to pure equities, this portfolio generated the lowest return of the three Schwab model portfolios. Its higher cash stake also hindered returns in a market environment in which safety wasn't a virtue.

Changes This portfolio's changes mirror the changes in the other portfolios, outlined above. I switched up the allocations to short-term and inflation-protected bonds, swapped in American Funds International Growth and Income in place of Harbor International, and cut commodities from the portfolio. However, because of this portfolio's smaller overall equity weighting, it didn't have a position in Diamond Hill Small Mid Cap, so the U.S. equity component remains the same.