We check up on performance and recommend a small tweak in our portfolio geared toward those with shorter time horizons.
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By Christine Benz | 03-06-14 | 06:00 AM | Email Article

Judging from reader responses to my aggressive and moderate retiree bucket portfolios, which I recently revisited, many retired investors are comfortable embracing a healthy equity stake in their portfolios. That's a sensible tack for retirees with longer time horizons or those who know that they want to leave money behind for their children, other loved ones, or charity.

Christine Benz is Morningstar's director of personal finance and author of 30-Minute Money Solutions: A Step-by-Step Guide to Managing Your Finances and the Morningstar Guide to Mutual Funds: 5-Star Strategies for Success. Follow Christine on Twitter: @christine_benz and on Facebook.

The conservative bucket portfolio has a more modest goal: preserving purchasing power and delivering living expenses for the retiree who has an approximately 15-year time horizon (that is, life expectancy). This portfolio does stake about 25% in equities, but it also holds about 58% of its assets in bonds and another 12% in cash. The remainder of the portfolio is in commodities and other securities, such as convertibles and preferred stock.

This week, I'll take a look at how the conservatively positioned portfolio has performed since I first introduced it more than a year ago. And as with the moderate and aggressive portfolios, I'll suggest a modest adjustment to help reduce the portfolio's sensitivity to interest-rate changes.

Let Time Horizon Lead the Way
The main idea behind the bucket approach is to segment the portfolio by the spending time horizon: Assets that will be tapped sooner are parked in short-term holdings, and longer-term monies are stashed in higher-returning, higher-volatility asset types, mainly stocks.

To construct a bucket portfolio, the retiree starts with anticipated income needs for a given year, then subtracts certain sources of income such as Social Security and a pension. What's left over is the amount of cash flow that the portfolio will need to supply each year. In the case of the conservative portfolio, one to two years' worth of living expenses (those not covered by Social Security, and so on) are housed in cash instruments (bucket 1), and another 10 years' worth of living expenses are housed in bonds (bucket 2). The remainder of the portfolio is invested in stocks and other more volatile assets, such as commodities and a high-risk bond fund. Income and rebalancing proceeds from buckets 2 and 3 are used to replenish bucket 1 as it becomes depleted.

As noted earlier, the conservative portfolio's focus is on capital/purchasing power preservation and income production, so it stakes roughly 70% in bonds and cash. That will likely strike many retirees and pre-retirees as overly bond-heavy. After all, starting yields are minuscule, and the next few decades are unlikely to be as kind to bonds as the previous three were. Yields will go up, but they'll hurt bond prices in the process.

In recognition of that fact, I've generally aimed to steer the portfolio away from the most interest-rate-sensitive bonds, and my one recommended adjustment (details below) further reduces the portfolio's rate sensitivity. Moreover, as with the moderate and aggressive portfolios, the specific parameters of the conservative portfolio can be altered to suit a retiree's own goals and preferences. For example, a more-risk-tolerant, growth-oriented retiree may choose to hold just one year's worth of cash in bucket 1 while also shrinking the number of years' worth of assets in bonds, thereby enlarging the equity stake as a percentage of assets. 

And though I've supplied specific fund recommendations in my model portfolios, a retiree needn't reinvent the wheel to put the bucket approach to work: Many of the key ingredients likely already appear in well-diversified retiree and pre-retiree portfolios. A total stock market index fund or a portfolio of individual dividend-paying equities could stand in for  Vanguard Dividend Growth , for example. Meanwhile, a retiree in search of simplification could use an all-in-one-type investment such as  T. Rowe Price Spectrum Income to supplant the individual holdings that make up bucket 2.

The portfolio includes three buckets, one each for short-, intermediate-, and longer-term spending needs.

Bucket 1: Years 1-2

Original Portfolio

  • $82,500 (11%): Cash (certificates of deposit, money market accounts, and so on)

Adjustments: None

This portion of the portfolio is geared toward meeting near-term spending needs. Because of this role, it sticks with true cash instruments, as noncash alternatives like ultrashort bond funds have lower yields and more risk than CDs right now. 

Bucket 2: Years 3-12

Original Portfolio

Adjustment: Use Vanguard Short-Term Inflation-Protected Bond Index (or the exchange-traded fund, which trades under the ticker ) in place of Harbor Real Return. The short-term fund provides a measure of inflation protection, in that it owns bonds whose principal values adjust upward to keep pace with the consumer price index, but it's less sensitive to interest-rate-related volatility than intermediate- and long-term Treasury Inflation-Protected Securities vehicles.

The other bucket 2 constituents remain the same and are designed, in aggregate, to preserve purchasing power and deliver income with a dash of capital appreciation. T. Rowe Price Short-Term Bond serves as the portfolio's next-line reserves in case bucket 1 were depleted and bond and dividend income and/or rebalancing proceeds were insufficient to refill it. Fidelity Floating Rate High Income, one of the most conservative bank-loan vehicles, provides both a cushion against rising bond yields (bank-loan yields adjust upward along with lending rates) and a measure of inflation protection (yields are often heading up at the same time inflation is).

Harbor Bond is the portfolio's core fixed-income holding; the PIMCO-managed bond fund has a good deal of flexibility to adjust duration (a measure of interest-rate sensitivity), invest in foreign bonds, and range across bond market sectors. Finally, bucket 2 includes the conservatively allocated Vanguard Wellesley Income, which is anchored in fixed-income investments but also holds roughly 40% in stocks, both U.S. and foreign.

Bucket 3: Years 13 and beyond

Original Portfolio

  • $120,000 (16%):  Vanguard Dividend Growth
  • $50,000 (6.66%):  Harbor International
  • $35,000 (4.66%):  Harbor Commodity Real Return
  • $50,000 (6.66%):  Loomis Sayles Bond

Adjustment: None

As the long-term portion of the portfolio, bucket 3 holds primarily stocks. Its anchor holding, as in the aggressive and moderate portfolios, is Vanguard Dividend Growth, an ultracheap equity fund that skews toward high-quality mega-cap stocks. I've also included a healthy stake in Harbor International, which, despite the impending departure of one of its comanagers, is still a top foreign large-cap fund choice. The equity portion of the portfolio includes limited exposure to small- and mid-cap stocks; investors who would like more exposure to that area might consider a fund such as  Vanguard Small Cap Index or  Royce Special Equity , recognizing that small caps could be due for a breather after a very strong run relative to large caps.

In addition to two equity holdings, the portfolio also includes a small stake in a commodities investment as well as a position in Loomis Sayles Bond. The former is in place to provide an additional layer of inflation protection, whereas the latter supplies exposure to more aggressive bond types (and even stocks) that are not well-represented in bucket 2.

Performance
The bucket portfolios aren't designed to shoot out the lights in any one calendar year, and the conservative portfolio, in particular, will look weak in years in which stocks thrive. And thrive they did in 2013.

That said, since I introduced the conservative bucket portfolio in early November 2012, it has bested a portfolio of inexpensive index funds mirroring its asset allocation. It clocked an 8% return during that time frame, whereas the blended benchmark gained less than 7%. Although bonds greatly underperformed stocks during that time frame, the bond portfolio's noncore positions--floating-rate bonds and junk bonds, for example--beat the Barclays Aggregate Bond Index and gave the total portfolio a lift.

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