Ready Your Portfolio for Retirement

Christine Benz: Hi, I'm Christine Benz. And welcome to the final session of our Morningstar Individual Investor Conference, Ready Your Portfolio for Retirement. I'm going to be talking about some of the key challenges facing retirees today as well as some of the central ingredients that belong in every retiree's portfolio.

I'm going to be discussing the bucket strategy for managing a retirement portfolio, and I'll also share some model portfolios that I have developed that use the bucket concept.

We will be taking questions. My colleague Jason Stipp will be coming out toward the end of this presentation to help me tackle some questions.

My slides are also available for you. [You can download the slides here].

So let's go ahead and get started. I wanted to talk about why the current environment is so challenging for retirees. And a lot of you will be familiar with the trend that is depicted on this slide, namely, that if you want to stick with very safe securities, the interest-rate environment has been very, very cruel.

I did a presentation similar to this one a couple of years ago, and, unfortunately, the interest-rate climate, at least for short-term products hasn’t improved a lot. It's very difficult to earn a livable yield from your certificate of deposit, your money market investments. This is in sharp contrast to those who are lucky enough to have retired in the 1980s. They did have runaway inflation to contend with, but they did have much, much higher yields.

The net effect of this is that investors who want a higher yield have to edge out on the risk spectrum somewhat. So we can see, if you are willing to take on a little bit more interest-rate sensitivity in your portfolio, you can pick up a higher yield certainly than you can earn in CDs or money market funds, but it's not a lot higher. The Barclays Aggregate Bond Index, for example, just has a yield just a little bit over 2% currently. If you wanted to stick exclusively in Treasury bonds, it's under 2%. For municipal bonds, you can earn a little bit more, but you have a little bit more risk arguably because you have some municipal finances under a cloud. You can see that you can pick up an appreciably higher yield by venturing into long-duration bonds. At this point, the yield is nicely over 4% currently, but you're also picking up a lot of interest-rate-related volatility with such a product.

I recently looked at the duration [a measure of interest-rate sensitivity] for a long-term bond index, and it's in the neighborhood of 14 years. One thing we often use to try to get our arms around how interest-rate-sensitive such a portfolio would be, is it you take that duration statistic, subtract the yield from it, and the amount that you're leftover with, in this case 10 percentage points the difference between that 14-year duration and the 4% yield, that 10 percentage points is roughly the amount you could expect to see that index lose in a one-year period in which interest rates trended up by just 1 percentage point.

You can see, you are able to earn a better yield on such products, but it comes at the expense of substantial interest-rate-related volatility. Needless to say, a lot of investors are not comfortable taking that risk right now, particularly given that interest rates have a lot more room to move up than they do now.

How about if you're willing to take more credit risk? This is certainly a trend that we've been seeing among investors. We've heard numerous panelists [at the Morningstar Individual Investor Conference] allude to this fact that investors are gravitating to some of these higher-credit-risk fixed-income types. You can see that the yields are better in many cases than what you can earn on high-quality bonds. High-yield bonds, for example, currently have yields well over 4% typically for the big core funds, high-yield funds that you might find out there.

Emerging-markets bond funds also have yields in that neighborhood. Multisector bond funds don’t have yields quite as high, but they are definitely attractive relative to high-quality bonds. And floating-rate or bank-loan funds, that’s another category that various individuals have discussed during this conference, that's a category that has seen a lot of interest in part because the yields are pretty attractive relative to high-quality bonds.

The trade-off, though, of some of these bond types is that you also get a lot more credit sensitivity. You get a lot more sensitivity to the direction of the economy, and you get a lot more sensitivity to what's happening with the equity part of your portfolio.

These bond types, while they can be valuable additions to investors' fixed-income portfolios, will not provide that same ballast that high-quality fixed-income types might do for you. So I’ve provided here just a little bit of context, where you can see the losses that these investment types incurred in 2008.

I'm not saying we’re going to find ourselves back in a 2008-style environment, but it’s just here to show you the type of equity sensitivity that you’re getting with these products. The losses weren't quite as high as what one would have gotten with a pure equity portfolio, but they were certainly in the same ballpark. So that's something to bear in mind if you’re thinking about adding these investment types to your portfolio.

You can see that if you have a plain-vanilla 60% equity, 40% bond portfolio, your yield isn’t all that exciting, in this case, just over 2%, currently. And here again, you do have significant equity sensitivity.

If you are going to venture into a higher-dividend-yielding product for the equity piece and a higher-yielding fixed-income product for the bond piece, you can see that the yield is a lot better here. It’s quite attractive relative to what that 60/40 balanced plain-vanilla portfolio had. But what you have here is also a lot more loss potential. So this is marrying together a high-dividend-yielding equity index ETF with a high-yielding bond index ETF, and you can see that its performance was substantially worse in 2008 versus that plain-vanilla portfolio.

What is an investor to do given that the raw materials for an income strategy just aren’t adding up right now? You can certainly use income-producing investments for a portion of your portfolio, but I would argue that retiree portfolios really need to include a gamut of other ingredients, as well.

The first one and really a key one that we'll run throughout this presentation is that in my view retirees today need to focus on total return, not just exclusively on current income. That’s not to say they don’t want to own income-producing securities--they absolutely should--but they should embed them within a total-return framework.

And the key reason gets back to the slides I just showed you, that for many investors it’s difficult to deliver a livable yield using income-producing securities alone. A better strategy in my mind is to use income-producing securities but also leave open the idea that you might be opportunistic about where you go for cash on a year-to-year basis.

At the end of 2013, for example, I argued that one of the best things retirees could do for themselves was to actually rebalance their equity portfolios, sell some equities, because the equity markets had such a tremendous run, and use some of that money for living expenses versus gunning for current income.

So I think this is such an important concept, and I will be discussing it further in the context of the bucket portfolios that I’ll share with you later on.

A component of guaranteed income is another key ingredient. Thankfully most of us will come into retirement with at least one of these elements of guaranteed income, so this is Social Security, perhaps a pension for some individuals, or perhaps some sort of a single premium immediate annuity. The idea is that you want to supply your portfolio plan with some baseline of living expenses, and then your portfolio only has to supply the rest. But as I said, the good thing is that most people do have some element of guaranteed income as part of their portfolio plans.

A sustainable withdrawal rate, we could do this whole presentation on this topic because it is such an important one, but the key thing to bear in mind is that you want to make sure that whatever amount you are withdrawing from your portfolio in terms of income, capital gains distributions, or rebalancing, that it doesn't exceed the level that experts normally considered to be reasonable. So, we've all heard about the 4% rule, and what that means is that you withdraw 4% of your portfolio in year one of retirement and then you gradually inflation-adjust that figure as the years go by. That's one way to do it.

Another strategy, and this is one that I've heard that for many Morningstar.com users about, they really like to use a fixed withdrawal rate, so they are using 4%, but they are using it on a year-to-year basis. The benefit they say, and I think it's a valuable thing to note, is that it makes their withdrawal rate more sensitive to whenever their portfolio is doing. So, when their portfolio is way down, they're willing to tighten their belts and stick with that fixed withdrawal percentage.

But the important point is to make sure that whatever withdrawal rate you're using in managing your retirement portfolio that it is within the realm of sustainability. So anytime run the numbers and looked at withdrawal rates that are running over 5%-6%, you are getting into a danger zone that might not be sustainable over your entire retirement. It's important, though, to underscore some of the assumptions that underpinned that 4% rule. Specifically, it looked at a roughly 60% equity, 40% bond portfolio, and it assumed a roughly 30-year time horizon.

If your portfolio plan looks substantially different from those parameters, you may be able to use a different withdrawal rate. So, for example, if you're 85 and you are using the 4% withdrawal rate, that might in fact be too low, given your life expectancy, especially if you didn’t have a strong goal to leave additional monies for your children and grandchildren.

In addition to the previous factors, you also want to make sure that your portfolio plan includes a stable pool of assets to draw your living expenses from. This is really the linchpin of the bucket strategy. The idea is that, you've set aside money, usually one to two years' worth of living expenses, in truly safe instruments. And, granted, when you factor in inflation, this may well be dead money for you because we saw the very low rates that are available on truly safe securities right now. But the idea is that you are parking the money that you expect to need in the near term, and it’s not going to be harmed at all by market fluctuations. And so your longer-term portfolio can do what it's going to do; you know that you have the money set aside to fund your near-term living expenses.

You don't want to get fancy with this portion of the portfolio. You don't want to start venturing into riskier asset classes. You want to keep it safe. You want to keep it in guaranteed or near-guaranteed investments like CDs and money market funds. I sometimes talk to investors who tell me that they like to have even more than one to two years' worth of living expenses set aside in these truly safe investments. In that case, you might consider building a two-part bucket [for bucket 1].

And this might hold true CDs, money market funds, and so forth, as well as perhaps a high-quality short-term bond fund, such as T. Rowe Price Short-Term Bond. But the idea is that you don't want this position to be too large because there is opportunity cost associated with having so much money hunkered down in true cash.

A measure of inflation protection, why you need it is simply that, as you are no longer earning a paycheck, you're no longer eligible for those cost-of-living adjustments that you were able to earn, hopefully, while you were working. You may have some form of inflation protection. If you're taking Social Security, your payments are inflation-adjusted, but that's only a portion of your living expenses.

You need to make sure that that portion you're withdrawing from your investment portfolio also has some inflation protection embedded into it. The best way, long term, to make sure your portfolio is inflation-protected is simply to have some stock investments in your portfolio because that is the best way to outgun inflation over very long periods of time.

You can think about some additional categories though Treasury Inflation-Protected Securities or I-Bonds are ways to explicitly inflation protect your portfolio. So you receive a little inflation adjustment in either of those types of investments.

You might also look to other categories like commodities. The theory there is that as you're having to pay higher prices for the stuff that you need to buy to live your life, that you are participating in the price gains of those commodities as they increase. If you have some sort of a commodities-tracking investment, that means that even as you're having to pull more out of one pocket, you can perhaps put a little more in the other one.

Then there are other categories like floating-rate funds, which some of my colleagues have done some research on and have shown to be quite advantageous from the standpoint of protecting against inflation. But you need to make sure that that whole portfolio does have some insulation against inflation to make sure that inflation doesn’t gobble up the purchasing power of the money that you have in that portfolio.

A growth component for longevity--I just touched on the importance of having stocks in your portfolio to help provide some insulation against inflation, but stocks are also important because many retirees will be retired for 25 or 30 years or even more. So that means that you can’t just hunker down in truly safe securities, in cash and bonds. You absolutely need that growth engine for a portfolio. Even if you’re someone who is further on in retirement, I would argue that you still need at least some equities in the portfolio.

The ability to put a plan on cruise control. This is another topic that is so, so important. I often talk to investors in my travels where they are the person in their household who manages the investments, and they love it. The problem is, oftentimes they have a spouse who doesn’t love it, who is not that interested, is not that engaged, is not even that aware of what’s going on. So as you go into your retirement and certainly as you get further in your retirement, it becomes more important to build a plan that has that element of cruise control, that needs to be able to run itself for a time being if need be.

You can do that by having that cash set aside, that bucket 1, as I just discussed. That way if something should happen to you or if you should just not have interest in managing your portfolio for a while, at least you'd know that your near-term cash needs were covered. So that’s one idea.

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Another idea is simply simplifying your investment mix, and that’s why I think index products can make so much sense for retiree portfolios because they give you a lot of diversification in a single shot.

Finally, and I’ll just touch on this briefly, but it’s very, very important. You need to have some documentation about what it is you’re doing with your portfolio plan--some easy-to-understand document that says what your strategy is, what investments you hold, and where to go for income. And you need to make sure that whoever will take over your investment plan, if you’re unable to do so, knows where that document is and knows how to gain access to it.

Tax efficiency is another huge topic and one that I work on a lot on Morningstar.com. This is important because most of us will come into retirement with multiple pools of assets. So we might have Traditional IRAs and 401(k)s. We might have Roth assets. We might have taxable assets. And that’s advantageous because that tax diversification can be really valuable to us in terms of lowering our tax bills in retirement.

We need to stay plugged into the tax efficiency issue. We need to pay attention to issues like asset location, what types of assets we hold and which of these accounts. We need to pay attention to where we go for cash on a year-to-year basis, how we see sequence the withdrawals from those various types of accounts. We also need to think about managing those taxable assets in the most tax-efficient manner possible.

This is really a whole topic unto itself, but it’s really important to stay tuned, stay plugged into, the various pools of money that you have in your investment plan and make sure that you are maximizing the tax benefits of those tax-sheltered wrappers and reducing the tax drag on your tax-sheltered accounts.

If you have an accountant on who you work with on a regular basis, that person can earn his or her keep many times over by counseling you on a year-to-year basis about where to go for income, which pool of money to draw your assets from.

In a lot of ways this bucket strategy, which I mentioned, I think pretty elegantly helps pull a lot of these elements together. So here’s a simple framework that I've sketched out.

Bucket 1 is simply that cash bucket as I've discussed, and it holds truly liquid investments, maybe amounting to roughly one to two years' worth of living expenses.

The next bucket, bucket 2 is the intermediate-term piece of the portfolio. The goal here is to cover us for maybe years three through 10 of retirement. This is holding mainly fixed-income investments ranging from short- to intermediate-term. I probably would forgo the long-term piece at this juncture. And at the tail end of this part of the portfolio, you might think about holding some sort of balanced product to provide you with a little bit of equity exposure because three to 10 years, that's a fairly long time horizon. You need the growth potential that comes along with stocks.

Finally, bucket 3 is the growth engine of this portfolio. This is primarily equities, well-diversified by style and by geography, and it's also perhaps including a little bit of the more aggressive fixed-income types. So if you have junk bonds or emerging-markets bonds in your portfolio, I would house them here as opposed to that bucket 2. The idea is that the growth piece of the portfolio is going to be a lot more volatile than buckets 1 and 2, but it's also going to be the highest-returning component of your portfolio. In good years you can use the money that you rebalance out of bucket 3 to fund your living expenses to refill bucket 1. I'll spend a little bit of time on bucket maintenance later on in the presentation.

I wanted to share with you some of the model portfolios that I've done, that showcase this bucket strategy, the idea isn't to create the best retirement portfolios that have ever existed, though I did choose from some of Morningstar's top picks in constructing the portfolios, but really the idea here is to show you how this would work in action using actual investments. So I made a couple of assumptions in putting together this particular portfolio. I assumed that we're looking at a couple who have $1.5 million portfolio. They would call themselves fairly aggressive. The portfolio nets out to have a roughly 50% equity stake, 50% bond-and-cash stake. They are using that 4% rule. So they are taking $60,000 in year one of their retirement, and then they’re going to inflation-adjust that number in subsequent years. Those are the basic assumptions that I used in constructing the portfolio.

You can see bucket 1. This is years one and two worth of living expenses at $120,000; nothing fancy going on here.

Bucket 2 is kind of stair-stepped by risk level. You can see we start with a high-quality, short-term bond fund. We then get into core fixed income. Here we are using Harbor Bond, which is a PIMCO Total Return clone that is a no-load fund. And then we've also got a little bit of inflation protection.

Incidentally, I changed this particular holding in the portfolio. Initially, I’ve been using a core sort of Treasury Inflation-Protected Securities fund. I decided that I didn’t want all that interest-rate-related volatility so we swapped into a short-term TIPS fund. But that’s the only change that I’ve made in this portfolio since it made its debut in late 2012. And then the caboose end of this portfolio is Vanguard Wellesley Income. It is primarily bonds, but does include some equity exposure, roughly 35% equity exposure currently. But it does give the portfolio little bit more get-up-and-go potential.

I would also note that the components, the various buckets, can be kind of sized based on your risk preferences. If you’re looking at this and saying, "Having 10 years of my living expenses sitting in cash and bonds really seems too conservative for me," you could arguably reduce the size of this bucket 2, maybe take it to years three through eight of retirement. None of this is set in stone, but it’s just here to show you how you might construct your own bucket portfolio.

Finally, bucket 3, this is for years 11 and beyond of retirement. This is primarily stocks. So we've used high-quality equity exposure. We're using Vanguard Dividend Growth as our core equity fund, but we're also using a little bit of the total market index to give us exposure to some areas that don’t show up in that Vanguard Dividend Growth product, which tends to be pretty underweight in technology. Vanguard Total Stock market gives us a little bit of exposure there.

We also include some active foreign equity exposure. Harbor International is the pick there. That's kind of value-leaning, high-quality international-equity fund. You can see as I mentioned that this portion of the portfolio does also include some more aggressive fixed-income exposure. I’ve used Loomis Sayles Bond to provide that exposure. I've also used a little bit of commodity exposure. I look to Morningstar’s Lifetime Allocation Indexes to help determine allocations like this, and typically they recommend just 5% or 6% a portfolio should go into commodities. This is 5% of this particular portfolio.

I also created an [exchange-traded fund] version [of the bucket portfolio] that largely mirrors the exposures of the portfolio of actively managed funds and traditional index funds. So this is an ETF version. You can see it's got the cash component in bucket 1, nothing different than what we had in the other portfolio. It looks a little bit different in terms of the fixed-income portfolio. We've got all index products, but we are also using a little bit of equity exposure at the tail end of this portfolio, in part, because there really aren't any great balanced type products similar to Vanguard Wellesley Income available in the exchange-traded fund space.

But generally speaking, we're trying to mirror the same exposure. So we are looking for a little bit of inflation protection. We're looking for the portfolio to be stair-stepped by interest-rate sensitivity. In a worst-case scenario in which that Bucket 1 were all depleted and we needed to get some additional cash to fund living expenses, that short-term bond investment might be our next-line reserves.

Then you can see, similar to the other portfolio, we've got a growth component to this ETF portfolio, as well. Here again we've used a dividend-focused product, Vanguard Dividend Appreciation ETF, to provide high-quality equity exposure. We're using some high-quality foreign exposure as well as exposure to some more aggressive fixed-income categories. So we have a high-yield bond index here as well as a local-currency emerging-markets debt index at the tail end of this portfolio.

If you wanted to make a really skinnied-down version of the bucket portfolio, this is what I would call the cruise-control version. It doesn't perfectly replicate all of the exposures that were in the other two portfolios, but it does cover the basics. It's got that bucket 1 in true cash. It has the fixed-income piece, short-term and intermediate-term bonds. I didn't bother with TIPS, thinking that bucket 3 is providing us with some inflation protection, because it's all equity. In this case, it's a global equity index, but one could also use separate index funds for U.S. and foreign-equity exposure.

We ran through some bucket stress tests [last summer] where we looked at the performance of these portfolios and specifically, we stress-tested that first portfolio that I showed you, the one that was composed of actively managed and traditional index funds. We just wanted to look at how this worked if we went back in time, and as I mentioned we first introduced these portfolios in late 2012, so they haven't been around since 2000.

We just wanted to see how they would have performed, and would they, in fact, have held their ground and delivered the retirees' living expenses during the time period we examined. We made some assumptions and you can read the fine print about what we did in terms of rebalancing and where we went for cash on a year-to-year basis.

But it was pretty encouraging in this first stress test that I did from 2007 through 2012. You can see that the portfolio ended the time period above where it started, so that was a plus. And it also supplied the money that was needed for living expenses. We were withdrawing that $60,000 per year adjusted for inflation. We didn't take the inflation adjustment in very bad years. For example, in 2008, we did not take an inflation adjustment.

But what we found was a pretty encouraging first snapshot of how this portfolio would have performed. We found that in general, it did deliver on what I would've expected it to do. And that cash bucket was pretty helpful, especially in 2008, knowing that we had that money to rely on, and we didn't have any of our bucket 2 or bucket 3 investments performing especially well. We knew we could spend what was in bucket 1 without having to worry about what that longer-term portfolio is doing.

We also ran a similar stress test where we looked at how this particular portfolio would have performed without that bucket 1 because over time having that cash in bucket 1 will be somewhat of a drag on returns. What we found was that in this particular period though, that cash was beneficial. So, not having to invade bucket 2, for example, for living expenses really helped buckets 2 and 3 rebound really nicely following 2008's market crash. This portfolio without that bucket 1 performed slightly worse than the portfolio that did have the bucket 1, but over time I would expect the bucket 1 to supply more peace of mind than it will supply return-enhancing potential, so we just need to keep your expectations in check on that front.

We took the stress test even further back at the request of some of our users. We went back to 2000, which in hindsight would have been a terrible time to retire because the retiree would be just about to face the dot-com crisis. What we found was that running the portfolio from 2000 through 2012 and using those same general rebalancing rules, we found that the portfolio not only supplied the living expenses during that time period, the required living expenses, but it also ended nicely above where we started.

This is encouraging, just a first set of stress tests. I think you should generally be careful when you're looking at anyone who has said that they have back-tested portfolios. Again, the idea of these model portfolios isn't to shoot out the lights, but it is to deliver a livable income stream as well as to generally hold the portfolio stable or perhaps even grow it over time.

What do you need to know before trying this bucket strategy at home? First of all, I would say that this bucket strategy isn't a call to completely upend everything that you have. If you've been a long-time Morningstar.com user and you really like your existing holdings, there’s no reason to reinvent the wheel. You can very much find the right slots very likely for your existing holdings. So that’s one point that I would say.

Another point is that, in my examples, they are pretty simplified. In reality, many of you will have multiple pools of assets that you'll be looking to for living expenses. So it could get a little more complicated. If you have taxable and tax-sheltered assets, you’ll need to overlay the tax-managed piece.

As I mentioned during the course of the presentation, the buckets can very much be right-sized in line with the retirees' own preferences and risk preferences. So you needn’t stick with the specific allocations to each bucket that I’ve laid out here. You can use your own parameters to develop your bucket strategies.

As I mentioned, over time, that cash bucket will be something of a drag on returns, not a huge drag, but it will provide the benefit of peace of mind. And, finally, bucket maintenance is really a critical component of keeping this whole thing up and running. I'll just touch on that briefly.

You can use the all-income-centric approach. You can spillover your income and dividend distributions into bucket 1 or you can use, what I call, the strict-constructionist total-return approach. So you can reinvest all those dividend and income distributions. And then refill bucket 1 strictly with rebalancing. That’s another way to go about it. That’s probably what my preference is, or you can be opportunistic. So I know I talk to a lot of investors who say they like this bucket approach. What they do is that they see how far their income distributions can get them in terms of refilling bucket 1, and then they use rebalancing proceeds to fill it up to complete the year or two years' worth of living expenses.

So that’s a quick overview of the bucket strategy, some of the essential ingredients that belong in all retiree portfolios.

We are now going to tackle some user viewer questions. My colleague, Jason Stipp, has just joined me. He has brought some questions for us, and I hope we can answer them.

Jason Stipp: Thanks, Christine. That was a great presentation.

Benz: Thank you.

Stipp: Do you like how I just magically appeared here at the end.

Benz: The magic of TV.

Stipp: I have a several questions. You were getting a lot of questions throughout. The first one I think is an interesting one. We talked about two things today: We talked about the bucket approach, and we also talked about economic moats and how those can be useful. And a reader is asking how these approaches are different. I think the answer to that is they're not mutually exclusive, that you could look at moats as you're building some of your buckets.

Benz: That's absolutely right. I can't emphasize enough how the bucket approach doesn't mean that you need to completely redo your investment strategy. In fact, the equity anchors that I had in the sample portfolios, I would say have a pretty wide-moat focus themselves. That Vanguard Dividend Growth fund, for example, often shows up as one of the funds with the highest share of wide-moat companies. Wide-moat companies are a great idea for retirement portfolios? Whether you're picking individual stocks or using some sort of fund, I think they are a terrific addition. They can be your core equity holdings.

Stipp: I know that you have in bucket 2 a small piece of dividend-paying stocks. So probably if you're looking for any equity exposure in bucket 2, wide moats or strong dividend payers would be a good way to go there.

Benz: That's absolutely right. The reason is that they will tend to be less volatile than other parts of the equity market. That's one reason that we didn't overdo it with just the total U.S. market ETF, although that would be a valid way to go, as well. But over time with the wide-moat dividend payers, they tend to have somewhat lower volatility than a broad market index.

Stipp: We got a question for someone who is a few years before retirement. They actually said what if you are five or 10 years before retirement or even 20 years. Is that too soon to be thinking about buckets? Should you think about something else as you are allocating? And if you’re way before retirement, what would you suggest to help people set an allocation at that point?

Benz: I think the value of the bucket strategy is mainly that it helps you view your portfolio based on your need for the assets. That's an important concept no matter what life stage you are in. So, say, you are someone who is 40, in that case you can see that you probably don’t have an imminent need for cash and bonds. You can go ahead and be pretty equity-heavy because you’re not going to need those safe investments. You're not going to need to fund living expenses anytime soon. As you get closer to retirement, though, you need to start making sure that you are carving out portions of your portfolio that can serve as liquid reserves. And so you need to start staging that portfolio by time horizon and risk level.

Stipp: One of the great things about the bucket approach is that it does put that money that you need really soon, the money that you would be drawing on really soon, in its own save little bucket, so you can feel assured that you have money that you'll need in the short term. If you’re well before retirement, you really don’t have a need for the bucket, so you’re going to definitely be much more in equities at that point.

Benz: Exactly. I think our colleagues at Ibbotson Associates have done some important work in the realm of human capital and careers. How careers might affect one’s asset allocation. So if you are, for example, in a risky profession where there is some possible threat of income disruption, you want to make sure that you have set aside some money in those very liquid investments in case you should have that income disruption.

Stipp: Alan asked a question: Can you do this with two buckets? Why not a two-bucket approach? One, bucket 1 that might have five years in cash, and then the remainder in maybe a 60/40 [stock/bond allocation] for bucket 2. Can you play it that simple?

Benz: Absolutely. Financial planner, Harold Evensky, who is really responsible for this bucket concept, that's what he does with his clients, where he just uses that bucket 1 as well as a total-return balanced portfolio. I think that's a great strategy. There's no reason you couldn't just squish my buckets 2 and 3 together and consider them one large bucket. And that can be particularly valuable if you are relying on rebalancing proceeds primarily to fund living expenses. You can just shuttle those rebalancing proceeds over into bucket 1 when it needs to be refilled.

Stipp: That raises a key point about how money might be moving from one bucket to another. Can you talk a little bit on the specifics of what sorts of activities might create the funds that would move from bucket 3 to bucket 2 to bucket 1?

Benz: I think it's important to bear in mind that the idea isn't to just spend through all of these buckets. My personal bias would be to periodically refill bucket 1 using rebalancing proceeds alone. And what we found in the stress tests we did was that that did a great job of refilling bucket 1, there was almost always something in buckets 2 and 3 that was outperforming and needed to be cut back a little bit. So I think that that can be a terrific strategy. The the goal of this strategy isn't just to spend through the buckets and suddenly end up with a bunch of equities at the end of your retirement. That's really not what's going on here.

Stipp: You're overall actually maintaining some kind of asset allocation across all the buckets and you want to make sure you're maintaining that allocation. And also the rebalancing has a bit of a tactical-light effect. So things that have done really well, you're going to trim a little bit; you're going to probably be adding some money somewhere else to something that wasn't doing quite as well, which means you get that benefit of being somewhat contrarian.

Benz: Absolutely. So at the end of 2013, as I mentioned in the presentation, the strict constructionist bucketer was really looking at that equity piece of the portfolio to supply living expenses because chances are the equity piece was way, way up, and it's a great way to take risk off the table in the portfolio, while also meeting your income needs.

Stipp: There is a question here about target-date funds, or all-in-one funds or funds that are very widely diversified across asset classes. Can you use those and the bucket approach at the same time or do you have to more of an either/or decision there?

Benz: I love target-date funds, but in the context of retirement, I'm less of a fan. One of the main reasons is that you can't rebalance in the same way that you can if you have separate investments dedicated to distinct asset classes. In 2008 for example, if you needed to get money out of your target-date fund to refill bucket 1, what you would get would be, you'd be selling proportional shares of bonds and stocks at that time. But you probably didn't want to sell stocks at that time; you'd probably rather hang on your stocks and maybe withdraw from your bonds, which had performed well. I do like the idea of target-date funds for accumulators less so for retirees because they can't do that picking and choosing about where they go for cash on a year-to-year basis.

Stipp: I remember looking at those stress tests that you did, even within some different kinds of funds. Some managers might have been a little bit out-of-favor; some might have been doing really, really well. And even some of that granularity allows you to rebalance and get some of those proceeds and get your alignment back. There is certainly a level of control there when you have more vehicles for sure.

We have a couple of questions related to stocks. One of them is: What's your opinion on the value of shifting some of your bond funds to fundamentally strong income-producing stocks? Maybe I'm worried about bonds, and maybe I want to get a little more exposure in dividend payers. What's your take on that?

Benz: I think it's a reasonable strategy for a part of a fixed-income portfolio. It's hard to give any one-size-fits-all recommendations, but I wouldn't take the bulk of my fixed-income portfolio and move it into stocks, even high-quality dividend payers. The income piece may be there, but the volatility profiles of the two asset classes are so very different. And I think one word I’ve heard again and again today is ballast. That's one thing you want. One of the reasons you have bonds is not so much that we all think they're going to be great returners in the decades ahead, but they will go down a lot less than equities in some sort of a market shock.

And so I don’t think you want to completely abandon that concept. I think bonds still deliver there. You might take, say, 20% of what you would otherwise earmark for bonds and put it into a high-quality, income-oriented stock portfolio. But I wouldn't go much further than that.

Stipp: You'd say that even in the current interest-rate environment that we have right now, one reader was saying, "Why should I be holding bonds because I think they are just going to get clobbered. Shouldn’t I prefer to have a little bit more in stocks?"

You could say, certainly, there is a higher return potential for stocks over the long term in any case. But bonds do feel like they are under cloud right now. I mean, you kind of have to hold your nose if you're going to rebalance back into bonds, but you would say, for the ballast it’s an important thing to do at this point?

Benz: It is, and you are right. I think Morningstar's Ben Johnson mentioned in the previous session just about how short investors' memories seem to be, that investors hate bonds. But in 2008, if they had a high-quality bond fund, they really loved it. And I don’t think that that characteristic is going away. I expect that bonds will still be that rock in an equity market shakeup. I think you need bonds in your portfolio, and you do have to hold your nose.

Stipp: An interesting question about dividends. Dividends, of course, throwing off income or providing income. This reader is saying, "Should I reinvest dividends, or should I take that income stream?" And I think that points to the fact, as you're saying before, that there are different ways that you can create income. So you might be able to pick and choose as you're refilling that first bucket for instance.

Benz: Exactly. A lot of investors do like to know that they are going to be spending that income, or that income that their securities kickoff will supply them with some of their income. That's fine, in that case, don't reinvest those dividend and income distributions; just plow them into bucket 1. If it doesn't get you where you need to be in terms of your living expenses, then maybe you can do some things around the margins. You can rebalance to try to get your income level in bucket 1 back up there.

Stipp: Here's an interesting question; we had actually a couple of questions about Social Security. This reader says, "If I can live off of pension and Social Security income alone--I don't need to take any investment income--should I the only in stocks at that point because I don't need to create income from my portfolio?"

Benz: It's a great question. The role of those certain sources of income and all of this. What I would say typically is that the starting point is you need to think about what income needs you have, and then think about how your certain sources of income--Social Security, pension, et cetera--how good a job they do at supplying you with those income needs. If they get you all there, I agree then this bucketing concept is much less important to you. You probably don't need buckets 1 and 2. You might reasonably have a higher equity weighting, but you probably do need a little bit of safe security exposure simply because there are emergency expenses that occur in retirement just as they do while we're working. So you need to make sure that you have some of that money set aside in safer investments rather than parking it all on stocks.

Stipp: I think again there is probably a behavioral sense there where it's going to give you a smoother ride if you have some ballast in that portfolio. It just can be hard to live through these downturns.

Benz: Exactly, again referencing Harold Evensky. He talked to me about how that concept just doesn't work with clients. So if you say, "Oh, your Social Security, your bond, is doing just fine." The client will say, "What bond? I don't have any bonds. All I have a Social Security." So you need to be careful because the behavioral part is huge.

Stipp: Of course those big losses can seem really magnified when you're looking at just that stock portion. We have a question here about different kinds of bond funds and where those might fit in. I think it's an interesting one, as the reader specifically asked about a multisector bond fund, which some guys will take on a little bit more risk. They might have more high-yield bonds in them. Where would you think about something like a high-yield or multisector bond? Would that have a place in a bucket strategy? It seems like it might be closer to bucket 3?

Benz: That’s where I had those types of products. Loomis Sayles Bond is the one I used in the first portfolio. It tends to split its assets between high-yield and some foreign market debt, as well as some stocks in some cases. So I have that particular fund because its volatility profile is really high. I did have that in bucket 3 with the equity piece. But that multisector category is a little bit of a weird one because there are different fund types that live there. So T. Rowe Price Spectrum Income, for example, tends to be a very conservative spin on multisector. That one you might hold in bucket 2. So it depends on the multisector or high-yield product. High yield I would certainly hold in bucket 3.

Stipp: So you really need to look under the hood and see what are you holding in that bond fund. Then you can sort of decide which bucket that might need to go into.

Here is an interesting question that we’ve heard a lot, and we actually had a couple of readers ask us. Richard was one of them. He said, "Can't [required minimum distributions] explode your withdrawal rate?" You talked about the withdrawal rate before. If your withdrawal rate would be less than what you required to take out of some of those investment accounts, what do you do about it? And another reader said, "Isn't the withdrawal rate a moot point if my RMD is forcing me to take out more?"

Benz: Such a great question, because it’s true. When you look at those RMD tables, you see that you start out under 4%, and then you are way over it after just a few years once you’ve passed age 70 1/2. The important concept to keep in mind is that even though you have to take those RMDs, no one is saying you have to spend them. If they are going to take you way over your ideal distribution rate, you need to reinvest them in your portfolio. For most people that will mean that money will go back into some sort of taxable account, but if you or your spouse is still earning an income and you have enough to cover a Roth IRA contribution, you can invest in a Roth.

Stipp: Another reader on that same point said, "I remove a large amount of RMDs each month and have to invest in taxable accounts. How should I invest to keep my taxes down?" Because that’s now a consideration given that that money is going from some sort tax-deferred account now into a taxable account.

Benz: Another important question. I would say you want to think about index funds, to the extent that you have equity exposure in that taxable account, and municipal-bond funds. Run the numbers. Generally speaking, anyone who is in that 25% tax bracket or above is going to do better looking at municipal bonds for their taxable portfolio versus taxable bonds. But use a bond calculator to see which is the better fit for you based on your tax rate. But munis, index funds and ETFs are good ingredients for taxable portfolios.

Stipp: There are certain tax managed funds as well that might be able to keep your tax liability down if you wanted to go with something like that?

Benz: There are, and I like Vanguard's tax managed funds quite a bit.

Stipp: This is an interesting question; it's a little bit more about asset location. So this reader is saying that they have investments that they will have to take RMDs on at some point and what happens if the market is down? And now I have to take an RMD from this account, and my assets in that account are down. How can you think about asset location where you know you're going to have to sell some securities and take money out? And you don’t want to sell them if the market is in a bad place.

Benz: Yeah. So one thing I would say is that even if you’ve decided that your tax-deferred account is a good receptacle for equity assets, I think you still need to set aside some liquid investments for those years where you wouldn’t want to sell your equities. There will be a lot of other years where selling equities to meet your RMD’s will be the right thing to do. Again, getting back to last year, that was probably where a lot of retirees were taking their RMDs from, from their highly appreciated equity holdings. But I think you do want to maintain a cash component to stay a little bit liquid there so you're not having to tap anything while it's at a low ebb.

Stipp: On a similar point, you've written an article before about how retirement portfolios have to do the twist.

Benz: Yes.

Stipp: What do you mean by that? So, what are some of the big-picture things about where you might place assets in retirement that investors should at least have on the radars?

Benz: So the key concept is that the optimal asset location for you when you're in that accumulation phase will change when you're in retirement. So you often hear of your taxable accounts when you're in accumulation mode as being your best receptacle for equities. But when you are retired, taxable assets are often recommended to be the first that are depleted, or at least you start there if you need to fund your living expenses. At some point you need to kind of move things around and perhaps have some safer investments in those taxable accounts to meet your living expenses so that the complexion of the portfolio and the tax character of each of these pools of money may need to change a little bit as you become retired and start thinking about where you'll go for money on a year-to-year basis.

Stipp: It seems like things get a lot more complicated.

Benz: They do. One important concept, and this is kind of evergreen and holds true for everyone, is that if people have Roth assets, generally speaking, that's where you want to keep your longest-term money. And that's true in your accumulation years as well as in retirement years.

Stipp: Because you can preserve that tax advantage for much longer, and it also has advantages for your heirs, as well.

Benz: That's exactly right. That's the longest-term piece of the portfolio.

Stipp: You've mentioned to Roth a couple of times, and we did have a question about rolling over into a Roth or converting into a Roth and what are some of the advantages and disadvantages. It can be a pretty thorny topic to figure it all out, but essentially why would you rollover into a Roth or convert into a Roth? Then, I know there are a few pitfalls that you have to keep in mind in doing that, as well.

Benz: The main reason that you'd want to consider that is if you have a good reason to believe that the tax bracket that you are in at the time you do that rollover or conversion will be lower than what you expect it will be in retirement when you begin taking money out of that account. That’s really the key question you have to ask. A lot of people say, "I have no idea," especially if their time horizon is very, very long. And for them and really for anyone I say that tax diversification is an important concept.

Even if you are not sure what your tax bracket will be, it might make sense to convert portions of that account to Roth just in case your tax rate ends up being higher in retirement than it is today. But anytime you are talking about conversions, work with an accountant who is well-versed in the math related to conversions, and make sure that you have the money on hand to pay the taxes due upon conversion. Really run some scenarios, and accountant can help you figure out just how much you can convert each year--and you can do partial conversions over a period of several years--each year to avoid pushing yourself into a higher tax bracket.

Stipp: If you’re converting from one type of account into a Roth, you will have to pay taxes at that point. You're saying that it’s important to have the money on hand to pay that and you shouldn’t pay that out of proceeds from taking money? Is it generally considered a good rule of thumb to have those funds available?

Benz: It is because you may pay a penalty on additional moneys extracted from the account to pay those taxes. It's a good idea to have the money for the taxes external to the IRA account.

Stipp: Not to get too far into the weeds on conversions. I know that if you have other IRA assets elsewhere, you can actually trigger some kind of a bigger tax liability if you are trying to convert just part of it because of the way the Internal Revenue Service looks at the proportions, right?

Benz: That’s right. There has been a lot enthusiasm about this backdoor IRA maneuver. So the idea is that you open a nondeductible Traditional IRA, then convert it to a Roth. There are no income limits on those conversions. That's why this is an attractive maneuver. People who have incomes above a certain level can't contribute directly to a Roth but they can do the conversion. The problem is, if they're doing the conversion and they have other IRA assets, maybe rollover IRA assets, the tax is due on that little pot of money that is getting converted and will be based on the proportion of money in the IRA that's never been taxed relative to that that has already been taxed. So your nondeductible IRA recent contribution might be just small potatoes compared with this total IRA kitty. But what you might inadvertently do is trigger a larger tax bill on that conversion than you may have bargained for. So check into that if you are someone who has a large pool of IRA assets separate from this new nondeductible IRA.

Stipp: For some people conversions can be valuable, but there are certainly some pitfalls. It's probably a good idea to check with a tax advisor to make sure you don't have any surprises. There is a question about how many holdings is this too many to have in the buckets. I think as we end up as investors put lots of holdings, our portfolios proliferate. But then again, there are some holdings that are widely, widely diversified. If you're trying to streamline a portfolio, how streamlined can you get?

Benz: I think you can get quite streamlined. That cruise-control version that I showed in this presentation showcased about how small you might want to get. I would hesitate to recommend any sort of all-in-one product. I mentioned the shortcomings of target date and balanced funds when it comes to in-retirement withdrawals. I do think you want at a minimum, equity exposure, fixed-income exposure, maybe ideally some sort of short-term fixed income exposure, as well as a cash piece. I think you can get it pretty skinnied-down, but I don’t think you want to get carried away with just cash plus some sort of all-in-one product to be your whole portfolio.

Stipp: For some of those reasons that we had discussed before.

A question about municipal bonds. This particular question was someone who had not a lot of in-state muni choices, and maybe they live in a state where the financial situation doesn’t look that great. But how to think about muni investing in general and where that might fit in and also just should you be concerned about munis at this point? I know you’ve interviewed some of Morningstar’s analyst on the muni market. So if you’re looking for a good source, maybe for bucket 2 and some tax efficiency, are munis something that you should be looking at right now?

Benz: I don't think you want to turn a blind eye to some of the struggles that municipalities are going through, Puerto Rico being the most recent example. But I do think if you invest in a good, well-diversified, low-cost bond fund, you mitigate some of those municipality-specific risks. Morningstar analysts, I know, like Fidelity’s muni shop a lot. I personally have some Vanguard muni funds in my portfolio. But I think if you go with one of those low-cost providers, where they really are concentrating on risk control, I think that it’s a reasonable place to be. But I would say that you probably don’t want to hold munis for your entire taxable fixed-income exposure. I think you do want a little bit of additional nonmuni exposure just to provide a little bit of extra diversification.

Stipp: You can go with a national muni fund that will give you federal tax even if you can’t get necessarily a state tax break.

Benz: Right. If you live in a very high-tax state, it may well be worth looking at one of the single-state funds, but for most people I think the muni national fund is the way to go, and I would urge people to be careful about where they shop in the muni space because a lot of the issuance in munis is longer-duration and a lot of the funds are long-term. For most people, I think if they want to keep it intermediate-term, that's probably a safer thing to do. They'll insulate themselves from some of the interest-rate-related volatility that will come along with long-term bonds.

Stipp: I'm glad you mentioned interest-rate risk because we had some questions on bonds, and I think people are worried about maybe the bond portion of their buckets. This reader is saying, "How can I mitigate some of the potential interest-rate risk in the bond part of my portfolio? What steps can I take? What's your take on it?"

First of all, how can you figure out how rate-sensitive you are, so how much you might lose?

Benz: I think that that's a great starting point, Jason. We've often talked about this duration stress test. I touched on it briefly in the presentation. The idea of looking for duration, finding the yield of the product and subtracting it from the duration, that's the amount that you would expect to lose in a one-year period in which rates trended up by 1 percentage point. So if you're looking at some sort of aggregate bond index today, that's a duration of roughly 5 years. The SEC yield is a little over 2%. So maybe that's a 3-percentage-point loss for such a product. We did see an actual stress test of rate sensitivity this past summer. So look on your holding's second-quarter returns. If that's a shocking, uncomfortable loss for you, that's maybe not the right product for you, but do a little bit of stress-testing.

In terms of mitigating interest-rate sensitivity, I think you want to be careful about going all short, especially for money where you have a time horizon of, say, five or seven years or longer because there's definitely an opportunity cost there, and we've seen it. Over the past three or four years, it seemed like all the smart money was converging around the idea of, "Rates are going to head right up from here. I should just shorten my whole portfolio up." And yet we've had periods where intermediate-term bonds have really outperformed short-term bonds and certainly cash. So I think you want to keep time horizon in mind. Use duration as a rough gauge; try to match it to your time horizon to see if you're in the right ballpark relative to your holding period.

Stipp: You mentioned trying to gauge the duration, and we had another good question there because a bond fund can lose value, for instance, if interest rates go up. And the readers are asking about individual bonds in the retirement portfolio as a way that you might not see that value come down like you might on a bond fund or you feel like, "Well, I'll hold it until maturity, and I'll get my money back." So, how should I think about individual bonds as a way to protect myself, so to speak, in a rising-rate environment? It doesn't really protect you right?

Benz: It doesn't. The one thing is that, as a smaller investor, even if you are a larger small investor, it can be difficult to build a large portfolio of individual bonds that's adequately diversified, so that's one thing I would bear in mind. The other thing is that even if you buy a bond and plan to hold it to maturity and rates go up, yes, you have insulated yourself against losses that you might incur in a bond find. The problem is you've also lacked yourself into a very low yield over whatever you maturity is. So there's an opportunity cost there you may sort of taking with one hand and giving back with another.

Generally speaking, I think in many categories the fund is the better choice for individual investors. Certainly in municipal bonds, if we were to ask our colleague Eric Jacobson this question, he would say that the trading costs can be very, very unfavorable for smaller investors. That's a place where we would generally counsel muni funds as the better bet versus individual bonds.

Stipp: It can be hard to research some of those individual issues, as well.

Benz: Absolutely.

Stipp: I think your point is a good one, if you are holding what turns out to be a lower-yielding bond after rates have gone up, you are going to see higher rates available, and you may end up wanting to sell that lower-yielding bond. You are going to take a loss on it anyway so you can get into some of those higher-yielding securities. It’s really only insulating you if you don’t sell that bond. But if you need to for some reason, then you'll have to take the loss.

Benz: That’s right.

Stipp: Christine, a great presentation. I think the bucket approach is so intuitive and so useful, and I think you have done a lot to advance that concept for investors. Thanks for that presentation today and for being part of the conference.

Benz: Thank you, Jason.