Note: This article is part of Morningstar's October 2014 5 Keys to Retirement Investing special report.
One of the key benefits to the bucket approach to retirement-portfolio management is that it's not a call to reinvent the wheel. If retirees and pre-retirees have well-diversified portfolios, it's likely that they already own the key ingredients for a successful bucketed portfolio: bucket one (cash and potentially short-term bonds), bucket two (bonds and perhaps a bit of equity exposure), and bucket three (mainly stocks).
Yet, when I'm out and about talking about the strategy, I invariably receive questions about what goes where. Can I hold bonds in bucket one? Do dividend-paying stocks belong in bucket two or three? Where do REITs and gold go?
With that in mind, let's take each of the buckets one by one. I'll discuss the complexion of the investments that might fit within each component of the portfolio, and also surface some specific investment ideas for each.
Goals: Liquidity, preservation of principal
Appropriate Investments:Cash and possibly a high-quality short-term bond fund
The name of the game for bucket one is liquidity: This bucket holds your living expenses for the next year or two of retirement, and knowing you have that money set aside should allow you to tolerate the fluctuations you'll inevitably experience in the intermediate- and longer-term portions of your portfolio. Although the cash instruments with the highest yields will ebb and flow over time, online savings accounts generally offer the best combination of liquidity and yield right now, as discussed in this article. Retirees who would like to maintain a slightly larger bucket one (that is, they'd like to hold two or more years' worth of living expenses) might consider pairing a true cash instrument with a high-quality short-term bond fund or exchange-traded fund. However, yields on short-term bond funds aren't appreciably higher than what you'd earn on an FDIC-insured cash vehicle right now, while interest-rate sensitivity could roil a short-term bond fund's principal values. For that reason, cash makes the most sense for short-term investors who don't want to risk even small principal losses.
Goals: Income, purchasing-power preservation, some growth
Appropriate Investments: High-quality bonds and bond funds, including inflation-protected bonds; balanced or allocation funds
Bucket two is a larger component of the portfolio than bucket one, so it's better diversified. In my model portfolios, I've earmarked bucket two for years three through 10 of retirement. I've also stair-stepped bucket two by risk level, starting with a high-quality short-term bond fund, moving on to a core intermediate-term bond fund, and ending with a conservative-allocation fund. I've employed that risk gradation because, in a worst-case scenario where the retiree needed more income than bucket one could supply, he or she could tap the short-term bond fund in bucket two as next-line reserves. Meanwhile, the longest-term portion of bucket two (the allocation fund) will be more volatile but also offers much more upside potential.
To help screen for bucket-two-appropriate investments, I used Morningstar's Premium Fund Screener. I searched for no-load funds rated Bronze and above that land in Morningstar's bond and conservative- and moderate-allocation categories. To help get rid of niche-y, more volatile bond types, I screened for funds rated as "core" investments by Morningstar's fund analysts. Premium users can click here to view the output of the screen, or to make their own adjustments. For example, investors whose primary investment wrapper is an IRA will want to skip past the municipal bonds included in my screen.
Note that the overall list has a high-quality emphasis and is dominated by longtime Morningstar favorites: bond and conservative- and moderate-allocation funds from Dodge & Cox, Fidelity, T. Rowe Price, and Vanguard. But the list also includes some less familiar names, including several fine allocation funds from Manning & Napier, as well as Mairs & Power Balanced (MAPOX) and Greenspring (GRSPX). The "core" part of our screen omitted niche-type bond funds like high-yield, multisector, and emerging-markets bond funds. Because of their higher volatility, I would include such bond-fund types in bucket three. My screen did, however, cut off one fund type that I consider worthwhile for bucket two: inflation-protected bonds. I've used Vanguard Short-Term Inflation-Protected Securities Index(VTIPX) in my model fund and ETF portfolios.
Appropriate Investments: Stocks (including U.S. and non-U.S.), niche-type bond funds such as high-yield and emerging-markets, high-volatility inflation hedges such as commodities and real estate
The growth engine of the portfolio, bucket three is dominated by equities. Optional holdings for investors in search of additional diversification include higher-volatility bond types (the aforementioned high-yield, emerging-markets, and multisector bond funds, for example) as well as higher-volatility inflation hedges such as commodities, gold, and real estate funds.
To help unearth a list of strong candidates, I also screened for no-load Medalist funds, but this time I looked for them among Morningstar's equity categories: equity funds (both domestic and foreign) that our analysts rate as core, meaning that they're generally well diversified and cover a broad swath of the market. Premium users can click here to see the complete list. It includes a strong complement of index funds--including fine core equity offerings from Fidelity, Schwab, and Vanguard, as well as actively managed funds from firms like Artisan, Primecap, and Oakmark.
For the higher-risk/higher-return fixed-income component of my model portfolios, I've gravitated toward Loomis Sayles Bond (LSBRX) because it provides one-stop exposure to a number of niche fixed-income asset classes; I also like that their management's value discipline keeps it out of those areas that are looking frothy. Fidelity Strategic Income (FSICX) is a solid fund with a similar strategy.
See More Articles by Christine Benz