We make a minor adjustment and check up on the performance of this ETF-oriented portfolio ideal for retirees with long time horizons.
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By Christine Benz | 03-13-14 | 06:00 AM | Email Article

The past few decades have brought huge challenges for retirees and pre-retirees: two market crashes, the ebbing away of pension plans, and dramatically declining interest rates.

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.

The bucket approach to retirement planning doesn't solve all of those problems. But as a total-return strategy, it helps retirees build a diversified portfolio that isn't overly dependent on whatever the interest-rate gods are serving up at any given point in time. In lieu of focusing strictly on income-rich securities, retirees using the bucket approach set aside a baseline of cash for near-term living expenses. Before that bucket runs dry, they can refill it with dividend and income distributions and/or rebalancing proceeds.

The years 2008 and 2009, during the financial crisis, provide a useful illustration of how the bucket strategy can help retirees deal with challenging conditions. Because bucket 1 holds enough cash to cover one to two years' worth of living expenses, the retiree wouldn't have to sell stocks or risky bond types, all of which suffered big losses in 2008, at a low ebb. The cash cushion would also allow income-focused investors to regroup as bond yields dropped dramatically lower and many financial-service firms slashed their dividends.

During the past month I've revisited my original bucket portfolios--aggressive, moderate, and conservative--making small tweaks to each and assessing performance during their rather short lives. Now it's time to take a look at the exchange-traded fund versions, which launched around the same time. Whereas the other portfolios stuck with traditional mutual funds--both actively managed and index products--these portfolios are composed entirely of ETFs.

And there's a lot to like about ETFs for retirees. First, the good ones are fairly cheap. And as retirees shift more and more of their portfolios into low-returning asset classes, such as cash and bonds, keeping expenses down is a great way to boost take-home returns. Broad-based ETFs (and index funds) also provide a lot of diversification in a single shot, and with no managers to monitor, retirees will have less day-to-day portfolio oversight. Finally, equity ETFs and index funds can be highly tax-efficient, an attractive feature for retirees with sizable taxable account balances. (Bond ETFs will receive similar tax treatment as bond mutual funds; there's no tax benefit to the ETF wrapper for securities that kick off ordinary income.)

Bucket Basics
My aggressive ETF bucket portfolio uses the same general framework and assumptions as the aggressive mutual fund portfolio. It assumes a couple with a 25-year time horizon (or longer), a fairly high risk capacity, and a $1.5 million portfolio. (Investors can, however, customize their portfolio amounts to suit their own portfolios' value.) It also assumes they're using the standard 4% approach to portfolio withdrawals, meaning they'll withdraw $60,000 (4% of their original balance) in year 1 of their retirement and inflation-adjust that sum in subsequent years. As bucket 1 is depleted, they will refill it using dividend and income distributions, rebalancing proceeds, or both. (My personal preference is the "strict constructionist" total-return approach outlined here, but many retirees tell me they like knowing that income distributions are contributing some or all of their cash flows and therefore fill up bucket 1 with that income.)

As with the mutual fund portfolios, I've employed three buckets here: bucket 1, for near-term living expenses; bucket 2, holding securities with an intermediate-term time horizon in mind, primarily bonds; and bucket 3, holding the portfolio's longest-term growth assets.

Bucket 1: Years 1-2

Original Portfolio

  • $120,000: Cash (certificates of deposit, money market accounts and funds, and so on)

Adjustment: None

As the liquidity sleeve of the portfolio, the focus of bucket 1 is stability with a modest dose of income. Yields on many cash alternatives, such as ultrashort bond funds, are currently lower than what you'd earn on true cash instruments. Meanwhile, such investment types don't guarantee--either implicitly or explicitly--that your principal value won't fluctuate. Thus, they're a poor substitute for cash right now, even though they may look more attractive when short-term yields eventually trend up.

Bucket 2: Years 3-10

Original Portfolio

Adjustment: Use  Vanguard Short-Term Inflation-Protected Securities in place of iShares TIPS Bond. Other positions remain the same.

The idea behind swapping in the short-term Treasury Inflation-Protected Securities fund is that core TIPS vehicles such as iShares TIPS Bond,  Vanguard Inflation-Protected Securities , and  Harbor Real Return carry substantial interest-rate-related volatility. Thus, changes in bond yields have a bigger impact on the funds' returns than the inflation adjustment. Short-term TIPS vehicles, meanwhile, promise less rate-related volatility and some insulation against unexpected inflationary pressures.

PIMCO Total Return is bucket 2's core fixed-income position, just as Harbor Bond (a near-clone of  PIMCO Total Return ) is the anchor fixed-income holding in the mutual fund bucket portfolios. As so-called "core-plus" products, which my colleague Eric Jacobson outlined here, they have the latitude to venture beyond the securities in the Barclays Aggregate Bond Index and take small positions in emerging markets and high-yield bonds. They can also position duration (a measure of interest-rate sensitivity) differently from the index.

This portion of the portfolio also holds a stake in a plain-vanilla short-term bond index fund to serve as next-line reserves should bucket 1 become depleted and income and rebalancing proceeds are insufficient to refill it. At the tail end of bucket 2 is a position in Vanguard Dividend Appreciation, which is also the main equity holding in bucket 3.

Bucket 3: Years 11 and Beyond

Original Portfolio

Adjustment: None

Bucket 3 is the growth engine of the portfolio and also has the longest anticipated holding period. Therefore, it features heavy equity exposure as well as smaller stakes in volatile, credit-sensitive bond types and commodities.

Vanguard Dividend Appreciation is the portfolio's largest position. Although its dividend is higher than the broad market's, at just over 2% it's not too much higher than the broad market's. But the key attraction here is a focus on quality: The fund focuses on highly profitable firms with histories of raising dividends. That makes it an appropriate anchor holding for investors at any life stage, but its below-average volatility makes it especially appealing for retirees. The portfolio also includes U.S. and foreign-markets index exposure, to bring its costs down and fold in sectors that aren't well-represented in Vanguard Dividend Appreciation, such as financials and technology.

Whereas the mutual fund portfolios include a stake in  Loomis Sayles Bond in bucket 3, the ETF portfolios take a piecemeal approach to riskier bond market sectors, taking small positions in a junk-bond and local currency-denominated emerging-markets bond fund. I prefer active management in some of these areas--especially junk bonds--but these ETFs should serve as reasonable aggressive kickers for the portfolio. A commodity-index-tracking ETF provides additional inflation protection.

Performance
The bucket portfolios aren't designed to shoot out the lights in a single year, but rather to demonstrate how a retiree might build a diversified portfolio that can provide them with the cash flows they need in retirement. Whereas the mutual fund portfolios all beat their blended benchmarks of index funds, the aggressive ETF portfolio lagged its custom benchmark since I introduced it in September 2012. (I created the benchmark using the broadest, cheapest bond, international, U.S.-equity, and commodities funds available as well as a cash component, mirroring the allocations of the starting portfolio.) The portfolio picked up ground on the fixed-income side: The ETF portfolio's holdings in PIMCO Total Return, Vanguard Short-Term Bond, and SPDR Barclays High-Yield Bond all helped it beat a total bond market index fund last year. However, core holding Vanguard Dividend Growth trailed a total U.S. market index fund last year, accounting for much of the shortfall during the past 15 months.

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