Strong equity and bond markets have boosted the Bucket Portfolio's value, but true stress tests have been few and far between.
By Christine Benz | 03-08-18 | 05:00 AM | Email Article

A strong equity market has provided a helping hand to many retirees for more than a decade, and it's given a boost to the Model Bucket Portfolios, too.

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 our portfolio simulation dating to 2000 through the end of 2017, the Aggressive Bucket Portfolio's value stands almost $600,000 above its starting value of $1.5 million. Our hypothetical portfolio--which uses the Aggressive Mutual Fund Bucket Portfolio as its baseline--has also supplied an additional $1.4 million in cash flows to our hypothetical retirees over that 18-year period.

Yet the strong equity and bond markets that have prevailed over that time frame mean that true stress tests have been few and far between. The Bucket Portfolios, which are geared toward people in retirement, include a cash component (Bucket 1) to help tide a retiree through difficult stock markets, treacherous bond markets, or both. But in practice the portfolios' cash stake has been valuable in just a handful of situations over the past 18 years: first in 2001 and again in 2008. Indeed, a portfolio fully invested in stocks and bonds (without any cash) would have outperformed our model portfolio, which includes two years' worth of living expenses in cash, over the past 18 years. Even though 2000 marked the start of the dot-com bust and the stocks dropped by more than 50% again from 2007-2009, stocks have nearly tripled since 2000. Bond fund investors, meanwhile, have enjoyed price appreciation, even though bond yields have dropped significantly since 2000. (Believe it or not, 10-year Treasuries were yielding nearly 7% at the beginning of 2000!) The poor cash investor has had to settle for ever-lower yields over that same time frame. On a returns basis alone, the cash stake has been dead money.  

Yet the cash holdings in the Bucket Portfolios have no doubt provided a valuable intangible to retirees who employ the system: peace of mind. And with equity markets lofty by many measures, the portfolios' Bucket 1 and complement of safer, lower-returning assets like short-term bonds may come in handy in a tangible way sooner rather than later.

A Bucket Overview
With the Bucket Strategy that underpins the model portfolios, a retiree uses his or her cash flow needs (above and beyond what's being provided from nonportfolio income sources like Social Security) to determine the portfolio's allocations. Cash-flow needs for the next one to two years (Bucket 1) are parked in the only asset that is guaranteed to not lose money over such a short time frame: cash instruments like money market funds and CDs. Cash-flow needs for the next eight years are earmarked for high-quality bonds (Bucket 2); over the past 25 years, the Bloomberg Barclays Aggregate Index has generated positive returns in 100% of rolling three-year periods. The remainder of the portfolio (Bucket 3) goes into stocks and higher-risk assets like junk bonds; because the retiree holds at least 10 years' worth of cash flow needs in Buckets 1 and 2, the higher-risk assets aren't so risky after all. Stocks have generated positive returns in 86% of rolling 10-year periods over the past 25 years.

In the stress test of my aggressive mutual fund portfolio, I assumed a $1.5 million portfolio with a 4% initial withdrawal, translating into $60,000 in year 1 of retirement (2000 in my simulation). That withdrawal amount is then adjusted annually to account for inflation. The portfolio used in the simulation is as follows. (There are variations between these holdings and the ones featured in the actual Bucket Portfolios; in some cases we've had to use proxies in the simulation to account for varying inception dates and strategy changes.)

Bucket 1: $120,000
$120,000: Cash

Bucket 2: $480,000
$130,000:  T. Rowe Price Short-Term Bond
$150,000:  Harbor Bond  
$100,000:  PIMCO Real Return
$100,000:  Vanguard Wellesley Income

Bucket 3: $900,000
$400,000:  T. Rowe Price Equity Income PRFDX
$200,000:  Harbor International
$100,000:  Vanguard Total Stock Market Idex
$125,000:  Loomis Sayles Bond
$75,000:  PIMCO Commodity Real Return Strategy

Performance Update
The years 2016 and 2017 were both strong ones for the markets and the Aggressive Mutual Fund Bucket Portfolio: All holdings generated positive returns in both years, and harvesting appreciated positions through rebalancing generated enough cash to meet our hypothetical retiree's cash flow needs and plump up the portfolio's allocation to short-term bonds. You can view the simulation in this spreadsheet (Microsoft Excel required).

The portfolio's equity positions performed particularly well in both years and contributed the most to the portfolio's growth. International equities, which had lagged U.S. since the financial crisis, came on strong in 2017. While Harbor International's recent performance has been underwhelming, it gained nearly 23% last year and was the portfolio's best performer.

Note that the simulation includes holdings that differ from our actual Bucket Portfolios. For example, Vanguard Dividend Appreciation, a current portfolio holding, wasn't around in 2000, so I used T. Rowe Price Equity Income, an active fund with an emphasis on quality and valuation. (The T. Rowe fund actually underperformed Vanguard Dividend Appreciation in 2016 and 2017.)

I've also made a handful of alterations to the portfolio (and to its Moderate and Conservative counterparts) since inception. For starters, I replaced T. Rowe Price Short-Term Bond with Fidelity Short-Term Bond following a ratings downgrade on the T. Rowe fund. And while my portfolio's original core equity position was Vanguard Dividend Growth, that fund closed to new investors in 2016, and I replaced it with Vanguard Dividend Appreciation, a still-open index tracker with a similar focus. I removed commodities exposure from the portfolios in late 2017, though the simulation includes commodities for the full year.

Maintenance Regimen Affects Asset Allocation
Central to making a Bucket Strategy work is periodically shaking money out of the longer-term buckets to refill Bucket 1 for the next year's living expenses, as well as rebalancing. I employed the following strategy to generate cash flow and rebalance; you can also see it reflected in the portfolio simulation.

  • Withdraw 4% from the portfolio in year 1 (2000) of retirement. Inflation-adjust that dollar amount annually, but forgo inflation adjustments in years in which the portfolio loses value.
  • Reinvest all dividends and capital gains.
  • Refill Bucket 1 using rebalancing proceeds. Portfolio rebalanced annually if position sizes exceed 110% of their original size. (This leads to more rebalancing opportunities than would be the case with classic rebalancing.)
  • If rebalancing proceeds are less than annual living expenses, pull the remainder of needed cash flow from Fidelity Short-Term Bond in Bucket 2.
  • If rebalancing proceeds are greater than annual living expenses, move any remaining proceeds into positions that have declined in value since inception.
  • If rebalancing proceeds are greater than cash needs and long-term positions are at original size, add additional monies to cash.
  • If cash holdings exceed three years' worth of living expenses and long-term positions are at original size, move additional monies to short-term bond fund.

This (admittedly idiosyncratic) approach to portfolio maintenance has had a few implications for the portfolio's behavior and its asset allocation. For starters, trimming positions that have exceeded 110% of their starting allocations yields more rebalancing opportunities than would be the case under a traditional rebalancing framework. Such an aggressive pruning strategy is beneficial in that those rebalancing proceeds can be used to meet the portfolio's cash-flow goals. But trimming each position when it hits 110% of its original value also means that winners--especially equities--don't have as much of an opportunity to run as would be the case under a traditional rebalancing scheme.

Moreover, the rebalancing system I used called for adding excess portfolio amounts to the short-term bond fund, once cash-flow needs have been met and all positions have been topped up to their original sizes. In a rising equity market like the one we've experienced, the net effect of that strategy is that the portfolio becomes progressively more conservative. Whereas the initial portfolio parked more than half of its assets in stocks, the current portfolio features 35% in equities, 50% in bonds (with a heavy emphasis on the short-term fund), 13% in cash, and 3% in other. Of course, our hypothetical retired couple would also be 18 years older; assuming they were 65 in 2000, they'd be 83 today. Given that and a not-cheap equity market, a more conservative asset allocation seems reasonable. At the same time, a lighter equity allocation--and the constrained long-term growth potential that it implies may or may not be what every retiree seeks. 

Securities mentioned in this article



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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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