We made one small adjustment to this ETF portfolio for retirees with midrange time horizons.
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By Christine Benz | 03-27-14 | 06:00 AM | Email Article

Succession planning is important for CEOs, but did you know it's also important for your retirement portfolio?

Even if you're an extremely engaged investor--and that's true of many Morningstar.com readers--it's important to have a backup plan in case something should happen to you. Will your spouse know where to go for cash to pay the bills? Have you tried to skinny down your portfolio to as few moving parts as possible, especially if you're in your later retirement years?

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.

That's where the bucket strategy, especially one involving exchange-traded funds or index mutual funds, can come in handy. The linchpin of the bucket approach is one to two years' worth of living expenses set aside in cash instruments. That way your household's near-term living expenses are covered regardless of what the market is doing.

And by using broad-market ETFs for the portfolio's long-term holdings, you're ensured low-cost diversification without having to worry about pesky issues like fund manager departures or style slippage. Need to rebalance? By using broad-based index funds, you can easily determine which holdings to peel back on and where to add.

ETFs are attractive retirement holdings from a few other angles, too. Because many retirees have large shares of their portfolios in low-returning investments like cash and bonds, focusing on very low-cost investments is an easy way to enhance take-home returns. Moreover, equity ETFs can be more tax-efficient than even their plain-vanilla index fund counterparts (which are pretty tax-efficient themselves). That's an advantage to the many investors who come into retirement with sizable shares of their portfolios in taxable accounts.

During the past few months I've revisited my bucket retirement portfolios composed of traditional mutual funds--aggressive, moderate, and conservative--which made their debuts in late 2012. I also provided an update on my aggressive ETF portfolio, which first appeared in the fourth quarter of 2012. I made a few small tweaks and also discussed performance to date.

This week, I'll take a look at the moderate ETF portfolio. As with the other portfolios, I'm making a small adjustment to the inflation-protected bond exposure in bucket 2, and I'll also run through performance so far.

Bucket Basics
My moderate ETF bucket portfolio uses the same general framework and assumptions as the moderate portfolio consisting of traditional mutual funds. It's geared toward a retired couple with a $1 million portfolio, a roughly 20-year time horizon (that is, life expectancy) and a moderate risk capacity. The aim of the portfolio is to meet their cash flow needs throughout their retirement years. It stakes roughly 45% of assets in stocks and the remainder in cash, bonds, and a small slice of commodities exposure.

Because their time horizon is shorter than the 30 years that underpins the 4% rule, they're using a slightly higher withdrawal rate of 5%--in this case, $50,000 in year 1 of retirement, with that amount inflation-adjusted each year thereafter. As bucket 1 becomes depleted, they can refill it using income from their dividend-producing equities and bonds, rebalancing proceeds, or a combination of the two.

As with the other portfolios, I've divided this portfolio into three components: the cash component (bucket 1), bucket 2 consisting of bonds and a high-quality dividend-focused fund, and a long-term growth sleeve (bucket 3).

Bucket 1: Years 1-2

Original Portfolio

$100,000 (10%): Cash (certificates of deposit, money market accounts and funds, and so on)

Adjustments: None

The goal of bucket 1 is to hold principal steady to meet upcoming living expenses. Therefore, its assets are earmarked for guaranteed investments such as CDs and money market accounts. Money market funds, while only implicitly guaranteed, also fit the bill. Because cash yields are currently so low, staking too much in so-called safe investments like these carries a sizable opportunity cost.

Bucket 2: Years 3-12

Original Portfolio

$75,000 (7.5%):  Vanguard Short-Term Bond Index ETF   
$75,000 (7.5%):  PowerShares Senior Loan Portfolio ETF     
$150,000 (15%):  PIMCO Total Return ETF    
$75,000 (7.5%):  iShares TIPS Bond ETF      
$125,000 (12.5%):  Vanguard Dividend Appreciation Index ETF

Adjustment: Use  Vanguard Short-Term Treasury Inflation-Protected Securities Index ETF instead of the iShares TIPS fund. The goal of the switch is to remove some of the interest-rate sensitivity that comes along with longer-duration TIPS vehicles like the iShares fund. As a short-term vehicle, the Vanguard fund provides inflation protection without a lot of rate-related noise.

The other holdings in the portfolio remain the same. I'm sticking with PIMCO Total Return as the portfolio's core fixed-income position. Although the firm has received scrutiny following the unexpected departure of former CEO Mohamed El-Erian and succession issues loom for 69-year-old Bill Gross, Morningstar's Eric Jacobson recently reiterated Morningstar's Gold Analyst Rating on the fund. And given the possible volatility in the bond market in the years ahead, I like the idea of using an active manager who has the ability to shorten duration (a measure of interest-rate sensitivity) and otherwise diverge from the Barclays Aggregate Bond Index to protect on the downside.

Bucket 3: Years 13 and Beyond

Original Portfolio

$100,000 (10%):  Vanguard Dividend Appreciation Index ETF    
$100,000 (10%):  Vanguard Total Stock Market ETF  
$100,000 (10%):  Vanguard FTSE All-World ex-US ETF  
$50,000 (5%):  PowerShares DB Commodity Index Tracking ETF    
$25,000 (2.5%):  SPDR Barclays High Yield ETF      
$25,000 (2.5%):  WisdomTree Emerging Markets Local Debt ETF     

Equities dominate the long-term component of the portfolio, but bucket 3 includes smaller positions in high-risk/high-reward bond types as well as a small stake in a commodities-tracking ETF. As in all of the portfolios, I've given the core U.S.-equity position a tilt toward quality by using a dividend-growth ETF as well as a total market index ETF. (Minimalists could easily use a total market index fund as their sole U.S. equity holding, however.)

Whereas the traditional U.S.-equity portfolios all employed  Loomis Sayles Bond for their "aggressive kicker" bond positions, there's no analog among ETFs. Thus, I employed small stakes in a junk-bond and local-currency-denominated emerging-markets bond ETF.

Performance
Due in large part to its ample equity exposure, as well as positions in noncore bond types like SPDR Barclays High-Yield and PowerShares Senior Loan Portfolio, the moderate ETF portfolio has generated strong absolute returns of about 13% since its debut in late 2012. Nonetheless, its return slightly lags that of a blended benchmark of broad index funds mirroring its asset allocation; that custom benchmark returned slightly more than 14% during that stretch.

Our ETF portfolio's positions in TIPS and emerging-markets bonds held it back relative to a broad bond market index fund. Moreover, Vanguard Dividend Appreciation underperformed a total stock market index tracker. Although the dividend fund's lack of technology and biotech stocks held it back in 2013's rally, I remain comfortable with its high-quality emphasis, especially for retirement portfolios.

See More Articles by Christine Benz

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