(By Christine Benz) "What about us older retirees?"
That's what many readers were likely wondering when they viewed my recent moderate and aggressive "bucket" portfolios for retirees. The moderate versions (both exchange-traded fund and traditional mutual fund) are geared toward retired investors with a 20-year time horizon and feature more than 40% in stocks and the remainder in bonds; the latter target investors with a 25- to 30-year time horizon and feature an even more aggressive 50% stock/50% bond allocation. Such heavy equity weightings are too risky for investors with shorter time horizons who are actively tapping their portfolios for living expenses.
This week I'll feature a shorter-term bucket portfolio, consisting of traditional mutual funds, for those more conservative retirees. Its asset allocation is roughly 25% stock, 10% cash, and 65% bonds and "other."
Buckets: What You Need to Know
Before delving into the portfolio specifics, let's first review what bucketing a retirement portfolio means. In short, bucketing involves segmenting a portfolio by time horizon. In the framework I've been using, the shortest-term bucket funds near-term cash needs and therefore focuses on ultrasafe cash instruments. Bucket 2 covers income needs for the middle retirement years and consists mainly of bonds, while the long-term bucket is for the late retirement years (and possibly for one's heirs). As bucket 1 is depleted, it gets refilled with assets from buckets 2 and 3.
One reason I've been enthusing about the bucket approach is that it takes an intuitive, needs-based approach to asset allocation. It's easy to get your head around why you'd want to hold your assets for near-term income needs in truly liquid securities and why you'd be willing to tolerate equity-market risk with assets you won't need for 10 or more years.
I also like the bucket approach because it's a total-return strategy, which makes sense given the current low-yield environment. As bucket 1 becomes depleted, investors can replenish it with bond and dividend income, capital gains distributions, rebalancing proceeds, and required minimum distributions from buckets 2 and 3. The advantage of this catholic approach relative to an income-only strategy is that the retiree can build a better-diversified portfolio--and therefore one with better risk/reward characteristics.
As with the aggressively positioned portfolios, I used a hypothetical retirement situation to construct the moderate bucket portfolio. In particular, I assumed:
- A married couple with a roughly 15-year time horizon and low to moderate risk tolerance.
- $750,000 in total portfolio assets.
- A 5.5% initial withdrawal rate, meaning that they will withdraw $41,250 of their portfolio in year 1 of retirement, then inflation-adjust that amount in each year thereafter. (Assuming a 3% inflation rate, the year 2 withdrawal would be $42,488.) Income from Social Security and other sources would be on top of the $41,250 distribution.
- The desire to spend all their money during their lifetimes (that is, no desire to leave a legacy).
- They hold all of their assets within a tax-sheltered account, so the aftertax withdrawal amount would be lower than $41,250. Those with large shares of their portfolios within taxable accounts will need to pay greater attention to tax efficiency, especially with the fixed-income portion of the portfolio. Municipal-bond funds rather than taxable bond funds might be appropriate.
- The retirees will take a strategic approach to their portfolio management (that is, long-term and hands-off) rather than employ a more tactical strategy. They will regularly move assets from buckets 3 to 2 and 2 to 1, a process that will make the overall portfolio more conservative over time.
For investors steeped in the 4% rule for sustainable portfolio withdrawals, a 5.5% withdrawal rate would seem to be overly aggressive. But as financial-planning expert Michael Kitces discusses in this video, the 4% rule stress-tested withdrawal rates during a 30-year time horizon. For investors with shorter time horizons, a higher withdrawal rate is reasonable and in this case could arguably even go higher than 5.5%. Meanwhile, those with retirement horizons of more than 30 years will want to withdraw even less than 4% during year 1 of retirement.
Retirees shouldn't think that they need to reinvent the wheel to adopt a bucket approach. For example, though I've provided specific dollar amounts below, they can be readily adjusted to suit smaller or larger portfolios. (I've supplied percentages to enable you to do so.) Moreover, the portfolios don't require you to start from scratch by scrapping your existing holdings. For those with reasonably well-diversified portfolios consisting of sturdy core positions, those can be readily swapped in instead of the specific funds I've mentioned below.
Bucket 1: Years 1-2
$82,500 (11%): Cash: certificates of deposit, money market accounts, checking and savings accounts, and so on.
Because this portion of the portfolio is in place to meet near-term income needs, the name of the game is stability; given today's low yields, its income production is bound to be modest.
Bucket 2: Years 3-12 $412,500
For this component of the portfolio, current income production is the key goal, along with principal stability and modest capital appreciation. Its holdings are staged from the quite conservative T. Rowe Price Short-Term Bond to Vanguard Wellesley Income, which holds roughly a third of its assets in stocks. In between I've included a floating-rate (or bank-loan) fund to provide a measure of protection in a rising interest-rate environment. Harbor Bond is the core fixed-income holding here, as was the case with the moderate bucket portfolio. Although Harbor Bond won't be impervious to rising interest rates, manager Bill Gross' flexibility to adjust duration and bond-sector exposure is a valuable attribute. Harbor Real Return is apt to be the most interest-rate-sensitive component of this bucket, but it will provide protection against an unexpected increase in inflation.
Bucket 3: Years 13 and beyond: $255,000
The lion's share of bucket 3, the long-term portion of the portfolio, is focused on stocks. As the sole domestic-stock fund, Vanguard Dividend Growth provides high-quality, mega-cap-focused exposure with relatively low volatility levels. Harbor International employs a value-oriented approach to investing in overseas markets. (Index enthusiasts could readily supplant those two holdings with broad stock market trackers, both U.S. and international.) Rounding out the portfolio are two smaller holdings: Harbor Commodity Real Return and Loomis Sayles Bond. The former supplies additional inflation protection, while Loomis Sayles provides exposure to lower-quality and non-U.S. dollar-denominated bonds. Because of its volatility, an aggressive bond fund like the Loomis Sayles offering is a better fit for bucket 3