Worthy stock options are plentiful, but some of our favorite bond choices aren't here.
By Christine Benz | 09-14-15 | 06:00 AM | Email Article

In previous articles, I've discussed how Fidelity, Vanguard, and T. Rowe Price investors can create "bucket" retirement portfolios consisting exclusively of the house brand of mutual 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.

But what about investors who would like the latitude to graze among fund companies--a Harbor fund there, an Oakmark fund there, and a Loomis Sayles fund thrown in for good measure?

Of course, most brokerage firms allow investors to pick and choose funds from various mutual fund providers, just as they can pick and choose individual stocks; investors may also be able to trade in certain funds without paying loads or transaction fees. Likewise, big fund shops like Fidelity, Vanguard, and T. Rowe Price all have brokerage arms that allow investors to buy not just the house brand of funds, but funds from other shops, too, as well as individual stocks and ETFs.

But Charles Schwab created the first mutual fund supermarket, and it's still the big kahuna in this space. While the firm has its own lineup of funds--including a solid suite of low-cost index funds and ETFs--fund investors know it as a way to buy funds from smaller shops without having to maintain many small accounts. For years, fund shops viewed placement on the Schwab supermarket shelves as their shot at the big time; the Schwab connection gave them reach that they'd be unable to earn on their own. (Of course, funds offered on a no-transaction-fee platform have to pay for that privilege by sending a portion of their expense ratios to the supermarket.)

This week, I'll take a look at how an investor might build a bucket retirement portfolio using the Schwab platform. For these portfolios, I've employed only those funds that are available without transaction fees or loads on Schwab's OneSource platform. However, it's worth noting that for buy-and-hold investors, paying a transaction fee may sometimes be cost-effective. Yes, the investor has to pay $76 to initiate a position in a non-NTF fund, but that cost can be quickly recouped if the non-NTF fund is cheaper than a similar fund that's available without a transaction fee. In the portfolio I've assembled below, for example, I employed the NTF  BlackRock Inflation Protected Bond . While it's solid, it earns a Bronze rating and is more costly than the Gold-rated  Vanguard Inflation-Protected Securities or  Vanguard Short-Term Inflation-Protected Securities Index , which do not appear on the OneSource NTF platform.

Bucket Basics
The central idea of the bucket strategy, as envisioned by financial-planning guru Harold Evensky, is to include a cash bucket to cover near-term cash needs. Bucket one lives alongside a long-term portfolio consisting of stocks and bonds; the main benefit of the cash is to provide peace of mind to help the retiree tolerate the fluctuations that will inevitably accompany the long-term portfolio. Even in a scenario in which the stock portion of the portfolio dropped precipitously, the retiree could spend the cash in bucket one and even move into the portfolio's next-line reserves--short-term bonds--without having to sell any stocks at a low ebb.

Of course, there's an opportunity cost to bucket one--it's a loser on a post-inflation basis--which is the key reason that I've limited it to two years' worth of living expenses. It's also important to note that the allocations in these portfolios are approximations; investors will want to use their own anticipated spending rates to influence the size of bucket one and, in turn, the size of the other buckets. For example, the investor who expects to spend just $30,000 of her $1 million portfolio each year would hold $60,000, or 6% of her total portfolio, in bucket one, 24% (eight years' worth of living expenses) in bucket two, and the rest in bucket three. Her spending rate is low, so she can theoretically tolerate a more aggressive portfolio mix.

It's also worth noting that the goal of these portfolios isn't to generate the best returns of any retirement portfolio on record, but rather to help retirees and pre-retirees visualize what a long-term, strategic total-return portfolio would look like. Thus, a newly retired investor could follow the basic bucket concept without completely upending existing favorite holdings.

Finally, investors should bear in mind that these portfolios are geared toward tax-sheltered accounts, so they include healthy doses of tax-inefficient bonds. Next week, I'll feature a tax-efficient Schwab portfolio.

Aggressive Bucket Portfolio
Anticipated Time Horizon: 25 or more years

Bucket 1: Years 1 and 2
8%: Cash (money market funds and accounts, CDs, checking and savings accounts, and so forth; specific percentages will vary based on the amount of assets and the retiree's spending rate)

Because the money in bucket one will be used for near-term spending needs, safety is the name of the game; we're sticking with cash.

Bucket 2: Years 3-10
10%: USAA Short-Term Bond
7%: BlackRock Inflation-Protected Bond 
15%:  Metropolitan West Total Return Bond

Bucket two, which consists of high-quality fixed-income holdings, was the most challenging bucket to populate using funds on the NTF Schwab platform. Many of Morningstar's Gold-rated bond funds do not have 12b-1 fees, which helps them keep their expense ratios down. Yet, many non-house-brand funds on supermarket platforms charge 12b-1s.

A handful of Morningstar's short-term medalist funds appear on Schwab's NTF platform, but my two favorites,  Fidelity Short-Term Bond and  Vanguard Short-Term Bond Index , do not. (I look for short-term bond funds to be as safe and "vanilla" as possible; this is not the place for pyrotechnics.) I opted for USAA Short-Term Bond to serve as the portfolio's next-line reserves in case bucket one is depleted and income distributions and/or rebalancing proceeds are insufficient to refill it. While it includes a healthy allocation to lower-quality bonds, it has reasonable expenses, a seasoned management team, and muted interest-rate sensitivity.

As noted above, I employed BlackRock Inflation-Protected Bond to provide inflation protection for the fixed-rate portfolio; it's solid and investors can buy in without a load or transaction fee.

I employed the Gold-rated Metropolitan West Total Return Bond as the portfolio's core fixed-income position. While I'll admit that I have some trepidation given the velocity of inflows into the fund recently, senior analyst Karin Anderson notes that the managers have done a reasonably good job of investing the new assets; while the fund's Treasury bond stake has ticked up, that's not unreasonable given the firm's concerns about liquidity in the bond market.

Bucket 3: Years 11 and beyond
20%:  Oakmark Fund
15%:  Schwab Total Stock Market
5%:  Diamond Hill Small-Mid Cap
5%:  Credit Suisse Commodity Return Strat A
10%:  Harbor International
5%:  Loomis Sayles Bond

Finding worthwhile equity funds is easy work on Schwab's NTF platform. While you won't find big Vanguard, Fidelity, or T. Rowe Price funds on offer, some terrific boutiques are represented on the list, and investors can also buy some funds that typically carry a sales charge on an NTF basis. I used Oakmark Fund, Gold-rated and a longtime Morningstar favorite, as the portfolio's core equity holding, though more risk-tolerant retirees could reasonably employ the more concentrated  Oakmark Select instead. I augmented it with Schwab Total Stock Market to help smooth out the active fund's sector exposure, provide a dash of exposure to small- and mid-caps, and to lower the portfolio's overall costs. I took a small position in Diamond Hill Small-Mid Cap; I love the simplicity of funds that provide small- and mid-cap exposure in a single shot, and the fund's value bias is promising, given that growth has trumped value over the past five years.

Harbor International, another longtime Morningstar favorite, serves as the portfolio's core equity holding. I also took small positions in Loomis Sayles Bond, to provide aggressive, noncore bond exposure, as well as a small commodities position, the Bronze-rated Credit Suisse Commodity Return Strategy.

Moderate Bucket Portfolio
Anticipated Time Horizon: 20 or more years

This portfolio contains the same holdings as the aggressive Schwab portfolio, differing only in its allocations to them. 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 (money market funds and accounts, CDs, checking and savings accounts, and so forth; specific percentages will vary based on the amount of assets and the retiree's spending rate)

Bucket 2: Years 3-10
10%: USAA Short-Term Bond
10%: BlackRock Inflation-Protected Bond
20%: Metropolitan West Total Return Bond

Bucket 3: Years 11 and Beyond
15%: Oakmark
10%: Schwab Total Stock Market Index
5%: Diamond Hill Small-Mid Cap

5%: Loomis Sayles Bond
5%: Credit Suisse Commodity Return Strategy
10%: Harbor International

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. 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 (money market funds and accounts, CDs, checking and savings accounts, and so forth; specific percentages will vary based on the amount of assets and the retiree's spending rate)

Bucket 2: Years 3-10
13%: USAA Short-Term Bond
10%: BlackRock Inflation-Protected Bond
25%: Metropolitan West Total Return Bond

Bucket 3: Years 11 and Beyond
10%: Oakmark Fund
10%: Schwab Total Stock Market Index
10%: Harbor International
5%: Loomis Sayles Bond
5%: Credit Suisse Commodity Return Strategy

Securities mentioned in this article

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Christine Benz has a position in the following securities mentioned above: OAKLX Find out about Morningstar's editorial policies.
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