And what should you do if it's not enough to live on?
By Christine Benz | 09-07-17 | 05:00 AM | Email Article

Since I began putting together model "bucket" portfolios five years ago, the "income" question keeps popping up. Income, as in, "How much do these portfolios yield?"

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 question is a logical one. After all, many retirees rely on their portfolios' income production to serve as their cash-flow generator in retirement, to help replace the income from their paychecks. It's also true that dividend income has contributed a huge share of the stock market's return over its history. For bond investors, the income they receive is by far the biggest percentage of their returns. There are lots of reasons to want your portfolio--retirement or otherwise--to generate income.

Yet constructing a portfolio with an overarching goal of income production has the potential to lead an investor down a bumpy path. On the equity side, a high current yield can be a signal that a company's growth prospects are so limited that the best use of capital is to return it to shareholders. Alternatively, a high dividend yield can be an outward sign that a company is in trouble: As dividend yield is derived from dividing a company’s yield by its current share price, nothing plumps up a yield faster than a shrinking denominator (share price). Meanwhile, bonds must pay out higher yields to compensate investors for extra risks; it's not for nothing that issuers of emerging markets and junk bonds must pay significantly higher yields to their bondholders than the U.S. Treasury does. At a minimum, a yield-focused retiree will have to put up with fluctuations in income thanks to the prevailing yield environment: When yields are rich they're living high off the hog. When yields are lean, not so much.

Today's persistently low-yield environment makes generating a livable income stream from a portfolio particularly challenging; income-centric retirees have been left with the unenviable choice of making do on less or taking more risk with their portfolios. Demonstrating another method for extracting cash flow from a portfolio was a key impetus behind my model bucket portfolios. The portfolios employ a total return approach, with the assumption that an investor will be able to meet his or her cash-flow targets with a combination of income distributions and selling appreciated winners.

But even though the portfolios weren't developed to meet in-retirement cash-flow needs with income distributions alone, it's worth examining how much income the portfolios kick off, and what investors should do in the likely scenario that that income stream is unsufficient to meet their cash-flow needs.

Bucket Portfolios in Review
To review, the bucket approach segments a retiree's portfolio by expected spending horizon. Assets for the next year or two go in cash, enough assets for the next eight or so years are earmarked for high-quality bonds, and the remainder of the portfolio can go into higher-returning, higher-risk assets, primarily stocks. The key attraction of this approach is that having enough in safe assets--cash and high-quality bonds--protects a retiree from having to sell stocks or other volatile assets in a downturn; the investor has enough safe assets to serve as a cushion. The net effect is that an older retiree with a shorter time horizon (i.e., life expectancy) would have a large share of his or her portfolio in safer assets (bonds and cash), whereas younger retirees would have a greater share of their portfolios in stocks. Spending rates are in the mix, too: Retirees--even older ones--who are taking only tiny distributions from their portfolios would have relatively more in stocks, whereas those who need to take larger distributions to meet living expenses would have more liquidity.

To date, I've created core model portfolios for mutual fund and ETF investors; each series has an aggressive, conservative, and moderate version. These core portfolios are designed for investors in tax-sheltered accounts (e.g., IRAs), but I've also created tax-efficient bucket portfolios (for investors' taxable holdings). And for investors who prefer to have their assets with a single firm, I've created fund-family-specific portfolios for Vanguard, Fidelity, T. Rowe Price, and Schwab supermarket investors. (We've aggregated all of the portfolios--along with related articles about bucket portfolio performance and maintenance--on this model portfolios page.)  

A Yield Checkup
Given that the portfolios were developed with a total return strategy in mind rather than a focus on current income, it's not surprising that their yields are underwhelming. The portfolios' cash positions, ranging from 8% for the aggressive portfolios to 12% for the conservative ones, have further weighed on yields, thanks to improving but still-low cash yields.  I calculated the yield for the core mutual fund and ETF portfolios, using SEC yield statistics to do so. (In a handful of cases, SEC yield statistics were unavailable, so I used the 12-month yield number instead.) The portfolios' yields are as follows:

Mutual Fund Bucket Portfolio Yields: September 2017
Aggressive: 1.92%
Moderate: 1.92%
Conservative: 1.94%

Given that these three portfolios' asset allocations vary significantly--and that bonds generally have higher yields than equities--it was somewhat surprising that yields on all three portfolios were within shouting distance of one another. The key reason is that even though the moderate and conservative portfolios have more bonds, including higher-yielding bond holdings like  Loomis Sayles Bond and  Fidelity Floating Rate High Income , they're also accompanied by higher cash positions than appear in the Aggressive portfolio.

ETF Bucket Portfolio Yields: September 2017
Aggressive: 1.92%
Moderate: 2.02%
Conservative: 1.95%

As with the mutual fund portfolios, the yields on the three ETF bucket portfolios are tightly bunched. Curiously, the moderate portfolio had a slightly higher yield than the other two portfolios. Holdings in higher-yielding bond ETFs like  SPDR Blackstone GSO Senior Loan and  iShares JP Morgan USD Emerging Markets Bond bumped up its yield. Meanwhile, its cash position isn't as high as the conservative portfolio's, so low-yielding cash was less of a drag.

But Still Not Enough to Meet Cash-Flow Needs
These yields are right around 2% across the board--and that's before taxes. Given that many retirees target a starting withdrawal of 4% from their portfolios, the yields on these portfolios would be insufficient to meet the cash-flow needs for all but the most wealthy retirees.

Where should retirees go for additional cash? The choices are twofold. In good market environments, such as the one that has prevailed for eight-plus years, they can draw additional cash-flow needs by harvesting appreciated winners. Such a strategy has the salutary benefit of helping to reduce a portfolio's risk level, as discussed here. While rebalancing hasn't been a benefit in recent years, it looks like a smart strategy now, given that market valuations aren't especially cheap. (Of course, I would have said that a year ago, too, and yet the market has appreciated sharply.) This article details the logistics of using rebalancing to extract cash flows from a bucket portfolio. 

In poor markets, a retiree who needs additional cash flows from his or her portfolio but doesn't have any appreciated winners to sell can draw additional living expenses from the cash bucket of the portfolio. If additional assets are needed to meet living expenses, above and beyond the cash on hand in bucket 1, a retiree could turn to his or her next-line reserves. In all of my bucket portfolios, I've included a high-quality short-term bond fund to fill that role. While high-quality short-term bond funds have the potential to incur losses, those losses are unlikely to be meaningful, if and when they incur. This article includes more detail on the logistics of bucket maintenance. 

Securities mentioned in this article

Ticker

Price($)

Change(%)
Morningstar Rating Morningstar Analyst Report
With Morningstar Analyst reports you can get our expert Buy/Sell opinions on over 3,900 Stock and Funds
Christine Benz does not own shares in any of the securities mentioned above. Find out about Morningstar's editorial policies.
Sponsored Links
Sponsor Center
d
Content Partners