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Lessons From Our Bucket Portfolio Stress Tests

Mon, 2 Sep 2013

Christine Benz's 2000-2012 simulations for bucketed retiree portfolios produced some interesting takeaways on rebalancing, the 4% rule, and more.

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Video Transcript

Jason Stipp: I'm Jason Stipp for Morningstar. Christine Benz, Morningstar.com's director of personal finance, recently ran a series of enlightening stress tests on so-called retirement bucket portfolios to see how the bucket approach would have fared in a tough early-2000s market environment. She's here to talk about some of the key lessons she learned in running those scenarios.

Thanks for joining me, Christine.

Christine Benz: Jason, it's great to be here.

Stipp: Before we get to some of the takeaways, let's just remind folks and maybe viewers who don't know what is the bucket approach?

Benz: The basic idea, Jason, is that as you are retired you want to carve out a certain amount of liquid dollars that you are going to use to fund near-term living expenses. The idea is that, if stocks and bonds gyrate around, you won't have to tap them maybe when they're at a low ebb, instead you can go to your cash to fund the living expenses. We wanted to see how a bucketed portfolio would have performed over a period of years to see if actually it was a workable strategy over the past, say, five or even 10 years.

Stipp: And certainly that time period gives us plenty of market environments to test for this bucket approach. One of the first takeaways you have is one that was really very severely questioned after the financial crisis, and that was, does buy-and-hold, does diversification really work because it seemed like everything suffered in 2008. And you found diversification does work.

Benz: It did work, as did buy-and-hold. But you needed to add an important component to that approach, and that is rebalancing. Periodically, every year we would look at what had performed best in the portfolio and scale back on the holdings that had performed best and steered at least some of that money to some of the underperforming positions. What we found was that that was a really profitable approach as academics have long suggested.

Almost on a year-by-year basis, when you looked at the things we were scaling back on, they went on to have not such a great year the following year. We saw in action that rebalancing and scaling back on the laggards and steering that money to the winning positions generally worked pretty well for us.

Stipp: It is important to note, though, that this would require you to do some rebalancing in some tough years where you would have to take money from bonds that performed actually pretty well in 2008 and put them back into stocks, which everyone was really freaked out about at the time.

Benz: That's right. This is very hard to do in practice. Our exercise had the benefit of hindsight, and we did stick with the rebalancing regimen regardless of what the market environment was. But I'm sure in practice, someone trying to employ a similar approach probably did have a few moments of anxiety along the way.

Stipp: The diversification we found interesting, as far as the number of funds that you had and the kind of precision that they gave you to different areas of the market. And we actually found that having some surgical precision helps you to rebalance with a bit more efficiency perhaps and get assets to certain areas that had underperformed and skim back on some that had performed a little bit better.

Benz: That's right. One thing we did in the stress test was that we did what I would call surgical-style rebalancing. At the end of each year, we would look at position size relative to starting position size, and on an individual-position basis, we would scale back those holdings that had performed very well.

I think that does give you a little bit more precision than if you are rebalancing strictly on a total asset-class-exposure basis. For example, you might have years where your stock/bond exposure didn't change a lot, but if you peek underneath the hood, you see, "Well, maybe that Loomis Sayles Bond fund really had a tremendous year; my high-quality bonds didn't do as well." Stripping back on Loomis Sayles Bond specifically removed some risk from the portfolio and let us add to holdings that hadn't performed as well.

Stipp: We found that this point was clarified a bit when we ran a stress test using a very simple, balanced fund. Although it did OK, you did see that there was some benefit to having a bit more granularity in your holdings.

Benz: Right. We wanted to see how the portfolio would have done if we had just really skinnied it down and made it as basic as it could possibly be. We did use Vanguard Balanced Index along with some cash holdings. What we found was that, in certain years, say, a 2008-style environment, it would have been great if we could have cut back on bonds rather than having to take some money out of the total portfolio. I do think that at least even if you are really trying to make your portfolio quite streamlined, you probably do want to have a stock component and a bond component rather than running your long-term portfolio with a single well-diversified holding.

Stipp: One of the challenges, I know for you when you were doing this was exactly what rebalancing protocols you would use. And we did find that different rebalancing protocols could give you quite different outcomes. This is an area, at least a takeaway, where it's worth spending some time thinking about what you want to do there.

Benz: Right. And our readers had some very useful debate below the article where they discussed some of these issues, and some readers rightfully pointed out that, I hadn't used a standard rebalancing procedure.

One thing that we did throughout the stress test was that we prioritized making sure that that cash bucket was back to its starting value. In most cases, we're trying to get back to two years' worth of living expenses in the cash bucket. And then in one of the rebalancing protocols, I actually added any additional funds to the short-term bond fund in the portfolio. And the net effect of that was a pretty conservative approach that left us with a lot in cash and short-term bonds.

If you were gunning for the maximum possible return in the portfolio, what you would probably do would be to distribute any additional monies proportionately into all the holdings. If you had extra money left over that you wanted to redeploy, probably a better strategy, if your aim was to maximize long-term returns, would have been just to deploy that proportionately.

There are a lot of different wrinkles to portfolio maintenance during retirement. And I think that these exercises did help illustrate some of the different variations and maybe help people think through what would be the best protocol for them.

Stipp: Yes, and what they want to accomplish ultimately.

We did find some interesting things about the cash bucket and how it was funded, especially at the starting point of some of our scenarios. What were the key takeaways there in the management of that bucket number one?

Benz: Throughout I assumed that we weren't spending bucket number one from the get-go, that we were coming into retirement with some additional living expenses to get us through that year number one. And one thing we found when we did deplete a year's worth of cash from bucket number one right out of the box was that throughout the whole period, we were trying to top up that bucket number one and none of our rebalancing proceeds, or very few of them, could go to long-term positions.

I think at a minimum most people who are employing a bucket strategy like this probably want to come into year one with a little bit of extra cash. They don't want to be depleting bucket one right from the get-go.

Stipp: And that way you can rebalance any assets you have at the end of the year into more productive areas of the market instead of just plowing it right back into cash?

Benz: That's exactly right. I just think it will be more productive overall if you come into it with a little bit of extra cash.

Stipp: You also ran a scenario without cash, and how did that turn out?

Benz: That was really interesting because I had done an interview a few months ago with Michael Kitces who is a noted financial planner, a real expert in this area. He argued that, the drag of cash that is implicit in having that bucket number one really does reduce the return of the portfolio. We did take a look at that, and what we found was that he is absolutely right, that the portfolio that did not have the weight of cash, which really has a negative real return right now, did outperform the portfolios with the cash bucket.

I think a couple of things people want to bear in mind though are that, first of all, the bonds in the cashless portfolio really did deliver a very safe and steady return throughout the time period. Bonds may not be there to deliver that helping hand in the future.

And the other thing, I think, that people want to bear in mind is that cash provides maybe an unquantifiable quality here in that it does provide some peace of mind. In an '08-type environment, someone who was not having to spend down his longer-term assets to meet living expenses might have felt a little more comfortable. [Those are] a couple of things just to bear in mind before you take your portfolio to cashless with the expectation that its returns will necessarily be better in the future.

Stipp: You used 4% withdrawal-rate rule where you take 4% in the year one, and then you adjust that amount for inflation in the following years. How did 4% work out? This is a very hot topic among our readers. Did it seem like it was appropriate that portfolio could withstand 4% even during these rough years that we had?

Benz: It absolutely did. It was interesting to see that in one of the stress tests we did, we started it in 2000 and ran it through 2012. Even if we had ended the exercise at the end of 2008 that person would have been doing all right with the 4% rule. That, I thought, was an interesting finding. We did forgo the inflation adjustments in the down years. But, generally speaking, 4% held us in pretty good stead.

I think the risk is, though, if one wants to extrapolate this and say, "How? Does it mean I can take 5% or 6%?" I would say, maybe not, mainly because of the great performance we had from bonds during this time period. It just may not be repeatable. I think that that's a very big issue. It's one of the reasons that you've been hearing some talk about maybe a 3% rule making more sense for people who are a little bit concerned about the prospects for bond and that 4% may in fact be a touch too high.

Stipp: The bucket portfolio approach, intuitively a very appealing approach. These stress tests would seem to confirm that it's absolutely worth investors' time to investigate the bucket approach. Thanks for joining me, Christine.

Benz: Thank you, Jason.

Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.

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