The firm's municipal-bond funds are solid, but we make some trade-offs on the equity side in the name of tax efficiency.
By Christine Benz | 06-28-15 | 06:00 AM | Email Article

There's no real magic to creating tax-efficient portfolios. On the bond side, favor municipal bonds, especially if you're in a higher tax bracket. On the stock side, broad-market index mutual funds and exchange-traded funds generally do a good job of limiting the drag of taxable capital gains; ditto for tax-managed equity funds. 

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.

Over the past month and a half, I've created tax-efficient model "bucket" portfolios for retired investors using funds from Fidelity and Vanguard. This week, I'll do the same for T. Rowe Price. 

As I noted in last week's article featuring model bucket portfolios for T. Rowe Price investors in tax-deferred accounts, the firm has long been a Morningstar favorite thanks to its sober management style and record of strong stewardship. But the process of building a tax-efficient T. Rowe portfolio highlights a few shortcomings in the firm's lineup for tax-conscious investors. While T. Rowe's municipal-bond funds are topnotch, it has fewer standout options to suit tax-conscious equity investors. The firm does field a lineup of basic equity-index offerings, but their costs are higher than many rivals' index funds and exchange-traded funds. Meanwhile, the firm's tax-efficient equity fund has a strong growth bias, including a heavy dose of mid-growth stocks; the associated volatility and its lack of dividend-paying stocks makes it less than ideal as a core equity holding for retirees. 

Bucket Basics
There are a few key items to note about the bucket approach that I've been using in these model portfolios. 

First, the long-term, stock/bond portions of the portfolio are designed with total return, rather than current income production, in mind. Thus, they assume that income distributions might help meet a portion of a retiree's income needs, but that he or she will also periodically rebalance, selling highly appreciated portions of the portfolio, to meet additional income needs. 

Second--and here's where the buckets come in--the approach assumes that a retiree will hold a cash "bucket" alongside that long-term portfolio. He or she will spend out of the cash bucket, then periodically replenish that bucket with income distributions and rebalancing proceeds. The value of the cash bucket is primarily psychological: Knowing that one to two years' worth of living expenses are parked in cash, the retiree can put up with the volatility that will naturally accompany the long-term portfolio. 

As with the other portfolios, I used Morningstar's Lifetime Allocation Indexes to guide the asset-class exposures for these tax-efficient T. Rowe portfolios. However, it's worth noting that retirees should customize their own asset allocations based on the extent to which they're spending from their portfolios. Say, for example, a retiree expects to spend 3% of her portfolio per year. Her bucket one (cash) would hold 6% of her portfolio (two years' worth of living expenses), her bucket two might hold another 24% of her portfolio (3% of her portfolio times eight years), and the remainder of her assets would go into bucket three. 

To help populate the portfolios with specific funds, I leaned on  Morningstar's medalist ratings. Because there weren't tax-efficient T. Rowe medalists in every category I wanted for these portfolios, I also consulted with T. Rowe specialists Katie Reichart, Greg Carlson, Elizabeth Foos, and Bill Rocco, all of whom are senior Morningstar analysts. 

Aggressive Bucket Portfolio
Anticipated Time Horizon: 25 or more years 

Bucket 1: Years 1-2
8%: Cash (certificates of deposit, money market accounts, and so forth; percentages will vary based on amount of assets and spending rate) 

As noted above, the size of this bucket should be dictated by a retiree's spending plan for this part of the portfolio. A retiree who is drawing more heavily from her taxable portfolio than the 4% per annum spending I've assumed here would necessarily have a higher percentage of that portfolio in bucket one, while one who is using RMDs to fund most ongoing living expenses (and downplaying taxable-portfolio withdrawals) would have a much smaller allocation. Of course, cash yields are extremely modest right now, so it's important not to stake too much in bucket one; the long-term opportunity costs are too great. Online savings accounts will tend to provide the highest yields today. 

Bucket 2: Years 3-10
10%: T. Rowe Price Tax-Free Short-Intermediate
22%:  T. Rowe Price Summit Municipal Intermediate  

T. Rowe Price Tax-Free Short-Intermediate fund serves as the portfolio's next-line reserves, to be tapped if bucket one is running dry and income distributions and/or rebalancing proceeds from buckets two and three are insufficient to refill it. While the fund isn't currently under coverage by Morningstar's analyst team, Foos says its focus on fundamental credit research, with an emphasis on midquality bonds, is adequately supported by the large and experienced analyst team. The fund also has a highly experienced manager in Charlie Hill, on board here since 1995, and its returns have been remarkably consistent, landing in or just outside of the short-term muni category's top third in each of the past nine calendar years. 

Hill also serves as manager of bucket two's core fixed-income position, the Gold-rated T. Rowe Price Summit Municipal Intermediate. Foos notes that Hill avoids interest-rate bets and generally avoids dicey parts of the muni market, such as Puerto Rican and tobacco bonds. Instead, he looks to differentiate performance through sector and credit selection, as periodic plays on various parts of the yield curve. 

Bucket 3: Years 11 and Beyond
45%: T. Rowe Price Total Equity Market Index
15%: T. Rowe Price International Equity Index  

As noted above, the equity piece of the tax-efficient T. Rowe bucket portfolios was more problematic than the bond segment. While the firm fields a lineup of solid actively managed funds, none of them are explicitly managed for tax efficiency; some of the funds that have recently had manager changes, such as  T. Rowe Price New America Growth , made sizable capital gains distributions in 2014. Meanwhile, the firm's Tax-Efficient Equity Fund looks better from a tax-efficiency standpoint, and its recent returns have been strong. But it has a big emphasis on growth stocks, including mid-cap names, which has contributed to extra volatility; in 2008, for example, the fund lost six percentage points more than the S&P 500. 

In the end, I decided to use T. Rowe's index funds to populate bucket three. While their expense ratios are certainly higher than competing index funds and exchange-traded funds, the drag of taxes on their returns should be limited. I used a total market index fund to supply U.S. equity exposure; while its costs are higher than the firm's Bronze-rated S&P 500 fund, it will tend to be more tax-efficient than owning an S&P 500 and extended-market index fund in tandem. 

On the international-equity side, I used T. Rowe's sole international-index option, T. Rowe Price International Equity Index, which tracks the FTSE All-World Developed ex-North America Index. Here again, its price tag is higher than competing index funds. However, Morningstar senior analyst Bill Rocco believes that within the firm's international lineup, it's the best bet to limit the drag of taxes on a forward-looking basis. Rocco also points out that the FTSE index omits emerging-markets and small-cap names, so investors in search of that exposure will need to hold a separate fund, ideally in a tax-sheltered account where taxable distributions wouldn't be an issue. 

Moderate Bucket Portfolio
Anticipated Time Horizon: 20 or more years 

This portfolio contains the same holdings as the moderate T. Rowe portfolio, differing only in its allocations to them. Its cash stake is the same, but because it's geared toward retirees with shorter time horizons, it includes larger positions in high-quality short- and intermediate-term bonds and smaller positions in equities. 

Bucket 1: Years 1-2
10%: Cash (certificates of deposit, money market accounts, and so forth; percentages will vary based on amount of assets and spending rate) 

Bucket 2: Years 3-10
15%: T. Rowe Price Tax-Free Short-Intermediate
25%: T. Rowe Price Summit Municipal Intermediate 

Bucket 3: Years 11 and Beyond
40%: T. Rowe Price Total Equity Market Index
10%: T. Rowe Price International Equity Index 

Conservative Bucket Portfolio
Anticipated Time Horizon: 15 Years 

In contrast with the aggressive and moderate portfolios, both of which emphasize growth to varying extents, this portfolio is geared toward older retirees with shorter time horizons/life expectancies. As such, its focus is on preserving purchasing power and funding living expenses; capital appreciation is secondary. Because its growth prospects are relatively low, it would not be appropriate for younger retirees unless they are extremely risk-averse and--more importantly--have more than enough money to last throughout their retirement years. 

Bucket 1: Years 1-2
12%: Cash (certificates of deposit, money market accounts, and so forth; percentages will vary based on amount of assets and spending rate) 

Bucket 2: Years 3-10
20%: T. Rowe Price Tax-Free Short-Intermediate
28%: T. Rowe Price Summit Municipal Intermediate 

Bucket 3: Years 11 and Beyond
30%: T. Rowe Price Total Equity Market Index
10%: T. Rowe Price International Equity Index

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Christine Benz does not own shares in any of the securities mentioned above. Find out about Morningstar's editorial policies.
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