Bucket Investors Aren't Sweating Lower Yields

Yields declined sharply in 2020 as the Federal Reserve lowered interest rates in response to the pandemic. Though interest rates have jumped recently, in December 2020 the 10-year Treasury bond yield was stuck below 1%.

For total-return-minded retirees using a bucket strategy, however, watching already-meager interest rates head down even further is a nonevent. That's because trimming appreciated holdings, especially stocks, can provide cash flows for bucket investors even as income distributions slow to a trickle. In off years for rebalancing, a cash bucket can serve as a buffer, providing cash flows and staving off the need to withdraw from assets when they're down.

In my latest simulation of the bucket approach, which stretches back to 2000, a hypothetical retiree would have been able to rely on a combination of rebalancing proceeds and short-term bonds to meet cash flow needs in 2020. The approach has also fared reasonably well over the whole of the simulation. Total cash flows from the initial $1.5 million portfolio--which started at just $60,000 per year but recently exceeded $100,000 per year thanks to near-annual inflation adjustments--would have topped $1.7 million from 2000-20. Meanwhile, the portfolio would have also grown a bit over that period, to just over $2 million at the end of last year. In other words, the portfolio would have gained about $2.2 million since inception--the $1.7 million in withdrawals and the additional $500,000 gain from the portfolio's starting level.

These results are encouraging, but it's also important to acknowledge that that strength owes largely to robust gains from bonds and especially stocks over the past two decades, not to any particular alchemy related to the buckets. The strategy is designed to provide consistent cash flows regardless of market environment, but there's no guarantee that retirees will be able to grow their principal as has been the case over the past two decades. And if the starting withdrawal rate is too high, no strategy--bucket or otherwise--can ensure that a retiree won't prematurely deplete his or her funds.

The Test Portfolio

For the simulation, I assumed that hypothetical retirees embarked on retirement with a $1.5 million portfolio in 2020, taking out $60,000 initially (4% of the balance) then inflation-adjusting that dollar amount in the years that followed. You can view the simulation in this spreadsheet (Microsoft Excel required). I gave them a raise of 3% for inflation in years in which the portfolio gained in value. In the handful of years when the portfolio lost value, I skipped the inflation raise. In 2020, that initial withdrawal rate of $60,000 had grown to more than $100,000, thanks to those inflation adjustments. (Note that actual inflation from 2000-20 was quite a bit lower than the 3% that I used for the simulation.)

I employed a three-bucket setup. At the outset of the simulation, I steered two years' worth of portfolio withdrawals into Bucket 1 (cash); another eight years' worth of cash flows in Bucket 2 (high-quality bonds and a conservative-allocation fund, Vanguard Wellesley Income VWINX); and the remainder of the assets into Bucket 3 (equities and a dash of aggressive fixed-income exposure).

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

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

Bucket 3: $900,000 $400,000: T. Rowe Price Equity Income PRFDX $200,000: Harbor International HAINX $100,000: Vanguard Total Stock Market Index VTSMX $125,000: Loomis Sayles Bond LSBRX $75,000: Pimco Commodity Real Return PCRAX (sold in 2017; proceeds reinvested into portfolio)

Note that there are variations between these holdings and the ones featured in the actual Aggressive Mutual Fund Bucket portfolio. Because the simulation goes all the way back to 2000, I had to use proxies in some cases to account for varying inception dates and strategy changes. For example, Vanguard Dividend Appreciation Index VDADX is the core equity holding in my model portfolio, but it wasn't around in 2000, the inception date for the stress test, so I used T. Rowe Price Equity Income instead.

I've also made some changes to the holdings in my actual model portfolios since their inception date. For example, I dropped commodities exposure in 2017, and in 2018, I swapped in American Funds International Growth and Income IGIFX in place of Harbor International. I also swapped in Fidelity Short-Term Bond FSHBX in place of T. Rowe Price Short-Term Bond when the latter was downgraded to a Morningstar Analyst Rating of Neutral. Finally, I've used Vanguard Short-Term Inflation-Protected Securities Index VTAPX instead of Pimco Real Return.

Bucket Maintenance

I used a pure total-return approach in the simulation, reinvesting all dividend and income distributions back into the portfolio and relying strictly on rebalancing to meet cash flow needs. In reality, a retiree could instead maintain a hybrid approach, spending organic income distributions and harvesting additional cash flow needs via rebalancing. To help pick off cash flows on an ongoing basis, I employed a somewhat idiosyncratic approach, trimming individual positions in excess of 110% of their starting values. The virtue of that rebalancing approach--if it could be called that--is that it supplied ready cash flows on an ongoing basis. When holdings dropped below their starting values, I used cash and the short-term bond fund to top them back up.

Such a glide path and maintenance routine will tend to be most appropriate for retirees who are risk-averse and/or expect to use all of their assets during their own lifetimes. But a conservative-sloping glide path won't make sense for every retiree. Retirees who have a higher risk tolerance, more assets than they'll need during their lifetimes, and/or strong bequest motives may wish to maintain static or even rising-equity asset allocations throughout their retirement time horizons.

2020 Recap

In 2020, all of the holdings in the portfolio employed at least a modest gain. As in 2019, plain-vanilla broad-market exposure--Vanguard Total Stock Market Index--delivered the strongest return in the portfolio. Pimco Real Return, an inflation-protected bond fund, supplied robust gains, too, as did the international fund in my simulation, Harbor International. Together, trimming those holdings supposed about half of the retirees' target $100,000 withdrawal for last year. The remainder of the cash flow needs came from trimming the short-term bond fund. The other positions in the portfolio remained the same.

Because of the aggressive rebalancing regimen and the strong performance of both equity and most bond holdings over the past two decades, the cash and short-term bond holdings in the portfolio had grown to about 40% of the portfolio as of the end of 2020.

Of course, every retiree is different--in terms of risk tolerance, risk capacity, and ultimate goals for his or her money. But given that our hypothetical retirees would now be in their 80s (assuming they embarked on retirement at 65), a more conservative posture for the portfolio makes sense. That's particularly true given the length of stocks' current bull run, and the fact that valuations, especially in the United States, are pretty steep today.