What to Drop in Your Buckets

Note: This video is being re-featured as part of Morningstar's 5 Keys to Retirement Investing special report. This video originally appeared in August 2012.

Jason Stipp: I'm Jason Stipp for Morningstar.

Christine Benz, our director of personal finance, has often talked about the "bucket approach" to retirement, a practical approach to help investors get their minds around how to deal with their portfolios in those golden years.

She recently on Morningstar.com created a model portfolio to illustrate what kinds of investments might you use in the bucket approach. She is here with me to give a little more definition around those investments today.

Christine, thanks for joining me.

Christine Benz: Jason, great to be here.

Stipp: So, you recently did put out a portfolio, but before we get to the investment selection, I'd like to talk about broadly what types of investments you would look for in these buckets. What are the buckets supposed to do and how does that inform what you put in them?

Benz: There are lots of different ways to create these in-retirement bucket portfolios. The simplest form is simply where you've got your cash bucket set up for near-term living expenses, and then bucket number two, which covers everything else--so that's stocks, bonds, and everything else that you might own.

The way that I typically envision this bucketing coming together is actually three separate baskets or buckets of securities. Bucket number one is that cash, safe, liquid reserve bucket that is going to consist of cash instruments mainly or possibly even some sort of a short-term, very high-quality "quasi-cash, but not quite cash" fund that will give you a little bit higher yield, but generally keep your principal pretty stable. So that's what's going in bucket number one, and that typically will cover one to two years of your in-retirement living expenses, preferably two.

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Bucket two is that intermediate-term portion. So the linchpin of that will be intermediate-term bonds, and the goal there for this portion of the portfolio is income, safety, inflation protection, maybe a little bit of growth potential. So, in the portfolio I constructed, I envisioned a time horizon of three to 10 years for that bucket number two. I included inflation-protected securities, high-quality intermediate-term bonds in the form of Harbor Bond was the core bond fund I used, as well as a little bit of growth potential that we got through Vanguard Wellesley Income, which is a fund that splits its assets between stocks and bonds. It's mainly bonds, but it does own some value-oriented dividend-paying equities.

Finally, the third bucket is that growth engine of the portfolio. That's the longest-term portion of the portfolio. So it is primarily anchored in stocks, including foreign as well as U.S. stocks. I also put within that portion of the portfolio some higher-volatility fixed-income holdings. The example I used was Loomis Sayles Bond. It's a fund we like a lot. It has a lot of flexibility, but also a lot of volatility. So I wouldn't put it in bucket number two with the other bonds; I'd hold it to three because of that volatility profile.

Finally, I also had a small sleeve of commodities exposure that we are getting through Harbor Commodity Real Return Fund. So the idea there is to deliver some inflation protection for that long-term portion of the portfolio.

Stipp: The idea behind the buckets is really setting out some of the jobs your portfolio is going to be doing for you over different time periods and being explicit about that, so then you can be more directed in the kinds of investments and the allocation that you have overall and where you put those investments.

When you were looking at the funds that you wanted to put into these buckets, did any characteristics jump out to you from across the board? What kind of investments were you using for this exercise?

Benz: The thing that people want to think about is, at the time you are building this bucket portfolio, you are getting ready for the distribution phase, and so at this point in your life, based on my interactions with a lot of retired people, they don't want to spend a lot of hands-on time with their portfolios; they don't want to have to baby sit it.

So, when I looked at the holdings for the portfolios, I tried to find things that one could hold for many, many years. Of course, I tried to anchor the portfolio in very low-cost investments, because we know if overall investment returns are muted in the decades ahead, and I think that's realistic, the best thing you can do for yourself is to make sure you are focusing on very low-cost investments. So, the bulk of the portfolios were anchored in low-cost investments.

And I also look for investments that I consider very low maintenance. So, I looked for a lot of flexibility in holdings in which we had big positions. Loomis Sayles Bond was one I mentioned; it is a fund with a lot of flexibility, broad tool kit. Another one would be Harbor Bond, which has a lot of latitude to change its duration up, venture among different bond sectors, and so forth. So, I think you want that flexibility.

And finally, I found when I looked over the funds that I had recommended in the portfolios, I also liked that subadvisory model, meaning that the asset manager isn't using all in-house captive managers to run the fund; they're actually hiring the management teams externally in many cases. And the reason I like that is that it gives you a little bit of protection. If the manager runs off the rails for whatever reason and isn't someone that they want to stick with, they can fire that person more readily and swap into a different manager. So, sort of like that arm's-length relationship that's built into subadvised funds as exemplified by several from Vanguard (the Wellesley Income Fund), as well as all the Harbor funds in the portfolio; they are all subadvised as well.

Stipp: So funds with broader mandates, funds that might have the subadvised structure, those folks are more explicitly hands-on for you, so maybe you don't have to do as much of that yourself, and you can enjoy more of those retirement years.

The last thing, Christine: There is some flexibility here just in the broad structure and how you arrange the buckets. You alluded to this a little bit earlier. What kinds of different versions of the bucketing system might you see? What kinds of customization might a retired investor use here?

Benz: Well, certainly in terms of investment type, you'd have a lot of latitude. So, one thing we were talking about with some of our users this morning was this idea of giving a portfolio a tilt. If you have a strong belief, for example, that emerging markets are a good place to be, you might carve out some dedicated emerging-markets exposure or give the overall equity exposure a little bit more of a tilt towards small-cap value, where the data point to there being some outperformance over long periods of time. So you could embed some of those tilts.

My portfolios tended to be pretty neutral--if anything they intended to, I guess, be somewhat conservative versions of whatever asset classes they were trying to capture. So, Vanguard Dividend Growth, which I used as the linchpin of the equity exposure, tends to be a conservative take on the broad market. So you can build on those tilts.

You can also adjust your number of buckets. So, I used three; you might use two, if you wanted to skinny it down and simplify a little bit. In fact, one of our Morningstar.com users was saying that he actually uses a cash bucket and then a balanced fund just to keep things super streamlined. I think that's reasonable.

Another thing that you could certainly adjust would be the balance between active and passive strategies. In the sample portfolio I created, it did include a blend of active and passive strategies, but if you were all-index all the time, you could certainly go that route and also lower your overall portfolio costs and also probably reduce the number of holdings in the portfolio. So if you wanted to get it down to, say, three or four or five holdings, you could readily to that using an all-index portfolio. It might be a little harder to have complete confidence in actively managed funds taking such large stakes in them, but with indexed funds you could more safely and comfortably do that.

Stipp: What about the amount of assets that you have in each bucket? What swing factors might cause bucket number three, for example, to be a bigger percentage of your assets or a smaller percentage of your assets when you total all the buckets together?

Benz: Well, time horizon, certainly. So, in the sample portfolio that I created I assumed a 25-year time horizon. Those are people who definitely need a large growth component. I also said that they had a high-risk tolerance or high-risk capacity, too. So they are not actually going to have to invade bucket number three until year 11 of retirement. They have a lot of time to ride out fluctuations in that equity portion. So time horizon is a big factor.

By contrast, someone who has, say, a shorter time horizon of 10 years, they probably want to maybe forgo that long-term component altogether and stick with bucket number one, safe stable stuff, and bucket number two, more intermediate term assets like bonds.

Also desire to leave a legacy for kids would also be another swing factor. In fact, some of our users have said that they use bucket number four for that. That's money they would like to segregate because they have a real goal of leaving money for their children and grandchildren. They want to make sure that they are not ever invading that during their lifetime, so they are setting it aside, keeping it mainly in equities because that's the longest-term piece of their portfolio.

Stipp: Christine, the bucket approach is a flexible one, but also a very practical one. Thanks for giving us some more definition around those buckets and what goes in them.

Benz: Thank you, Jason.

Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.