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Lessons From Our Bucket Retirement Portfolio Stress Tests

Jason Stipp
Christine Benz

Jason Stipp: I'm Jason Stipp for Morningstar. Morningstar's Christine Benz, our director of personal finance, recently did another series of retirement portfolio stress tests, and she has some key takeaways to share with us today. Christine, thanks for joining me.

Christine Benz: Jason, always great to be here.

Stipp: Before we talk about some of the takeaways, let's talk about the stress tests that you performed. This time around, you did three of them.

Benz: We did three of them. We examined performance from 2000-13, and we looked at three different strategies for extracting cash flow from a portfolio. The first was a strict total-return approach. So, we reinvested all dividends and capital gains distributions, and we relied solely on rebalancing proceeds plus a cash component of the portfolio to fund living expenses. That was what we call the strict constructionist pure total-return strategy.

We also tested a more income-centric strategy--arguably sort of a naïve, income-centric strategy in that we let our income and dividend distributions fund living expenses on an ongoing basis. And we let those bounce around a little bit. So, we relied strictly on those income distributions. We didn't go to rebalancing if those income distributions perhaps fell below maybe a 4% withdrawal rate. We just relied strictly on whatever the portfolio was able to distribute. And with this particular portfolio mix, we focused a little more on income-producing investments. With the equity-income piece, for example, we focused on a fund that has a notably high income-distribution rate, Vanguard Equity Income (VEIPX), in that particular portfolio.

The third strategy we tested was a hybrid strategy. Here, again, we used income distributions to fund living expenses. If they fell short of our targeted amount, we look to rebalancing proceeds to make up the difference. The idea was to use that pure 4% rule strategy where we had our 4% of initial withdrawal in year 2000 and then we just inflation-adjusted that dollar amount thereafter.

The only portfolio that had any sort of a cash component was that first strategy--that strict constructionist pure total-return approach.

Stipp: And we'll talk about that cash component as one of the takeaways. But the first takeaway from doing these stress tests is that asset allocation works.

Benz: It really does. Arguably, the period that we examined here, 2000-13, even though the tail end of it was very strong for equities, 2000 would have been a lousy time to retire. You would have retired right into that dot-com bust, recovered in the mid-2000s only to experience that financial crisis, which was even worse. So, it was a turbulent period. But the combination of holding bonds in the portfolio as well as holding some cash in that first strategy, that got us through. We were able to meet our distribution rate, and we were also able to end comfortably above our starting value using all three approaches.

So, the nice thing is, even though investors spend a lot of time noodling over their specific distribution strategy--and in fact, it's very important--if you have a balanced portfolio, I think that gets you probably 90% of the way there when it comes to making your retirement plan work, plus having a reasonable distribution rate helps as well.

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Stipp: Of course. One of the things with asset allocation, though, is that it only works if you remain diversified even through those tough times.

Benz: That's absolutely right. So, the big part of the strategy was that we really stuck with that diversified discipline throughout. In reality, we know that sometimes investors don't stick with the disciplined, balanced asset-allocation approach. They might tend to freak out during those market inflection points. Because we were doing some back-testing, we stuck rigidly with the strategy; we used a very disciplined asset-allocation framework throughout.

Stipp: And of course, that would mean rebalancing into stocks during times when stocks are really under a lot of pressure. So, it's not necessarily an easy thing to do during times of crisis.

Benz: That's right. Two of the three portfolios did employ rebalancing, and we found that to be powerful from a couple of standpoints. One is that it did help enhance returns. But also, being able to rely on those rebalancing proceeds in those years when income distributions fell short, that allowed the retiree employing income distributions plus rebalancing to maintain a pretty steady cash flow throughout retirement, which in my experience is something that many retirees want. They want a predictable stream of cash flow from their portfolio.

Stipp: So, asset allocation worked well for us; rebalancing in the tests where we did rebalancing also worked well is the second takeaway; third takeaway, you said that asset allocation actually would trump the distribution method that you were using--it was probably even more important to the final results.

Benz: So, when we looked at the results from all of these portfolios and the distribution amounts that came out of the portfolios, I think one thing that is reassuring to me is that you saw a lot commonality in terms of the end results. Even though we employed what I think are pretty different distribution strategies, from that income-centric approach to the pure total-return approach and a lot of investors bicker about the pros and cons of those two things. In the end, if you did have, say, a 50-50 or a 60-40 portfolio, I think your results would be pretty similar.

Stipp: So, it goes to show that probably the asset allocation in your portfolio is going to be the biggest determinant of your portfolio's performance over long periods. The last takeaway, again, let's go back and talk about cash because having a cash stake did have an effect on the performance in some of the stress tests, but it's not all about the bottom line at the end of the day either.

Benz: That's right. The portfolio that did employ that cash component did underperform the other two strategies, and cash was certainly a drag over the time period that we examined 2000-13. Think about what happened for bonds and interest rates during this period. You had a very favorable declining-rate environment over this period. It was very, very good to be a bond investor, not so good to be a cash investor because you were having to go from maybe 5% or 6% starting yields to barely positive yields at the end of this period. So, the cash was certainly a drag on performance. But I think one thing that is not captured in those raw return numbers is that, arguably, it provided some peace of mind for our hypothetical retired investor during some of these very difficult pockets for equities, especially during this period. So, you can't quantify its benefit, but I think it's arguably there for investors who don't mind having a little bit of drag on their return.

Stipp: Also, the other thing with cash is that although cash performed poorly especially in the last few years of your stress test, that doesn't mean that cash will always be a big drag from a return perspective?

Benz: That's a thing. I think arguably the period that we've just been through is not one that will be readily repeated in terms of the direction of interest rates. Things could be bumpier for bonds in the future. So, cash won't always look so terrible relative to fixed income. I still think that normal relationship will hold up where you'll see fixed-income instruments outperform cash over long periods of time, but I think over short periods of time cash won't always be as much dead money as it was in this particular strategy that we examined.

Stipp: Which, again, just goes back to the importance of asset allocation, including cash in that as well. Christine, some really interesting takeaways from a really interesting set of stress tests on retirement portfolios. Thanks for joining me.

Benz: Thank you, Jason.

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