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How Our Schwab Tax-Efficient Bucket Portfolios Have Performed

A soaring U.S. equity ETF has given all three portfolios a shot in the arm.

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I recently made significant adjustments to my core tax-deferred Bucket portfolios for Schwab supermarket investors, the result of a flurry of manager changes and analyst downgrades that occurred since the portfolios' launch three years ago.

When it comes to enact changes in any of the Schwab tax-efficient portfolios, however, I'll use a much lighter hand. In contrast to investing within a tax-sheltered account like an IRA, where you're free to make adjustments without tax consequences, trading within a taxable account can entail tax costs. The tax consequences of trading may be less (or not at all) onerous in down markets, but they can stack up after the type of sustained equity-market rally we've experienced over the past few decades.

The tax-efficient portfolios are designed to limit turnover; they're ultraminimalist. The equity components of the portfolios are composed of fine Schwab total market ETFs, which are the ultimate in "set it and forget it" ease. I don't foresee ever needing to make changes to those holdings. The municipal bond funds in the portfolio are actively managed and highly rated by Morningstar's analyst team.

Thus, I didn't see any reason to make any changes to these portfolios following my recent review. Yet the three-year mark for the portfolios is a good point to stop and take stock of performance. Thanks to terrific gains from total U.S. stock market trackers like  Schwab US Broad Market ETF (SCHB), the portfolios all gained more than the Schwab Bucket portfolios for tax-deferred accounts, which include a combination of index and active funds. (To be fair, the tax-efficient portfolios have slightly higher equity weightings.) The tax-efficient portfolios also limited the drag of taxes: Their asset weighted tax-cost ratios were all less than 0.33% on an annualized basis over the past three years.

The Bucket Brigade
A Bucket portfolio is simply a total-return stock/bond portfolio, managed with an eye toward delivering both capital appreciation and income with a reasonable amount of risk given the retiree's proximity to spending his or her money. Alongside that longer-term portfolio, a retiree also holds a cash bucket consisting of one to two years' worth of living expenses. The idea behind the cash piece, as envisioned by financial-planning guru Harold Evensky, is that it provides a psychological buffer in turbulent times. What retiree doesn't want to know where his or her cash is coming from for the next few years? That cash bucket can be spent on an ongoing basis, then periodically replenished with income distributions, rebalancing proceeds, or a combination of the two.

As with all of the other portfolios, I used Morningstar's Lifetime Allocation Indexes as a starting point for these portfolios' asset allocations. However, I eschewed categories that are notably tax-inefficient, such as Treasury Inflation-Protected Securities and junk bonds. To help populate the portfolios, I cross-referenced Morningstar's Medalist funds with Schwab's list of no-load, no-transaction-fee funds.

Aggressive Tax-Efficient 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%:  Wells Fargo Short-Term Municipal Bond (WSMAX)
22%:  BlackRock National Municipal (MDNLX)

Bucket 3: Years 11 and Beyond
45%: Schwab U.S. Broad Market ETF
15%:  Schwab International Equity ETF (SCHF)

Performance
3-Year Annualized Return: 8.91%
3-Year Tax-Cost Ratio (Portfolio): 0.33%
Schwab U.S. Broad Market ETF was by far the portfolio's best performer over the past few years, gaining nearly double that of Schwab International Equity ETF over that time frame. Stacked with many of the stocks that have performed best in the U.S. market of late-- Apple (AAPL),  Microsoft (MSFT), and  Amazon (AMZN) are its top three holdings--this and other total market trackers could feel the pain if these highfliers experienced a sell-off. The goal of the Bucket setup, however, is that a retiree would never have to touch depreciated assets when they're in a trough; he or she could "spend through" the more conservative portions of the portfolio in such an instance.

BlackRock National Municipal has also enjoyed strong results relative to other muni-national intermediate funds and even relative to the Bloomberg Barclays Aggregate Index over the past three years. Morningstar's analyst team recently upgraded the fund to Silver in recognition of its seasoned management team and sensible process.

Foreign-stock index funds tend to pay bigger dividends than U.S.-focused index funds, so the portfolio's biggest tax costs were from that holding. And the fact that the foreign-stock component is larger here than in the Moderate and Conservative portfolios helps explain why its tax costs were also higher over the past three years. (ETFs tend to have good tax efficiency, but the ETF wrapper is no shield against taxable dividend distributions.)

Changes: None.

Moderate Tax-Efficient 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
15%: Wells Fargo Short-Term Municipal Bond
25%: BlackRock National Municipal

Bucket 3: Years 11 and Beyond
40%: Schwab U.S. Broad Market ETF
10%: Schwab International Equity ETF

Performance
3-Year Annualized Return: 7.86%
3-Year Tax-Cost Ratio (Portfolio): 0.28%

With an equity weighting that's smaller by 10 percentage points, it's no surprise that this portfolio returned a bit less than its more aggressively positioned counterpart over the past three years. Like the Aggressive portfolio, this portfolio benefited most from its U.S. equity index exposure.

Because its equity weighting is lighter and most of the portfolios' tax costs come from equities, the Moderate portfolio had slightly better tax-efficiency statistics than its Aggressive counterpart over the past three years.

Changes: None.

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
20%: Wells Fargo Short-Term Municipal Bond
28%: BlackRock National Municipal

Bucket 3: Years 11 and Beyond
30%: Schwab U.S. Broad Market ETF
10%: Schwab International Equity ETF

Performance
3-Year Annualized Return: 6.42%
3-Year Tax-Cost Ratio (Portfolio): 0.23%

With just 40% of its assets in strong-performing stocks, this portfolio's three-year annualized returns were the lowest of the three portfolios. Accordingly, however, its tax-cost ratio was also the lowest of the three.

Changes: None

Christine Benz does not own shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.

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