How Has the Retirement Bucket Strategy Performed?

The drought continues for investors aiming to wring any type of yield from high-quality bonds, not to mention cash.

Although the Federal Reserve raised short-term interest rates by 0.25% in 2015--and is likely to do so at least two more times in 2016--that was a drop in the bucket. Cash yields remain stubbornly close to zero, and high-quality bond yields are just about 2%-3%--hardly a subsistence level for most retirees.

Helping retirees create a cash flow from their portfolios, even in an income-starved environment, has been a key goal of my "bucket" portfolios. The bucket portfolios are, at heart, conventional total return portfolios--but with the addition of a cash "bucket" to help ensure stable in-retirement cash flows despite the inevitable fluctuations in the long-term portfolio components. The liquidity bucket is periodically refilled using income, rebalancing proceeds, or a combination of the two. (This article explores the topic of bucket portfolio maintenance.)

I've created a number of bucket portfolios over the past few years, targeting retirees at different life stages with varying risk tolerances and risk capacities. Some of these portfolios consist of traditional mutual funds (including some traditional index funds), and I've also developed bucket portfolios composed of ETFs. And for investors who prefer to use a single brokerage firm or fund company, I've created single-firm bucket portfolios from Vanguard, Fidelity, T. Rowe Price, and Schwab. (All of my model portfolios, for accumulators as well as retirees, are here.)

The portfolios consist of Morningstar researchers' top-rated mutual funds and ETFs, and harness asset allocation research from Morningstar Investment Management. For those reasons, I expect them to perform well over time. But unlike many other model portfolios on offer, the goal of these portfolios isn't to crush it on the performance front. Rather, my aim is to showcase sound practices for in-retirement portfolio management. Investors should feel free to swap in their own favorite funds in place of the portfolio's holdings.

To help illustrate how the portfolios would have behaved in varying market climates, as well as how a retiree would extract cash flows from them on an ongoing basis, I've periodically provided performance updates, along with data illustrating investment returns and the portfolio-management regimen. My last performance review was in fall 2014. With two more calendar years of performance in the rearview mirror, I'll discuss the performance and portfolio management since then.

Portfolio Review Before we get into performance, here's an overview of the baseline bucket portfolio used in this performance illustration, along with the initial portfolio values. Note that the portfolio is geared toward a 65-year-old couple with a moderate risk tolerance.

Bucket 1: $120,000

$120,000: Cash

Bucket 2: $480,000

$130,000:

$150,000:

$100,000: Harbor Real Return HARRX

$100,000:

Bucket 3: $900,000

$400,000:

$200,000:

$100,000:

$125,000:

$75,000: Harbor Commodity Real Return Strategy HACMX (Because this fund didn't exist in 2000, the start of the stress test, we've swapped in Oppenheimer Commodity Strategy Real Return QRAAX instead.)

Portfolio Maintenance Regimen 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.

• Withdraw 4% from the portfolio in year one (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 one using rebalancing proceeds. Portfolio rebalanced annually if position sizes exceed 110% of their original size.
• If rebalancing proceeds are less than annual living expenses, pull the remainder of needed cash flow from Fidelity Short-Term Bond in bucket two.
• 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.

Performance Update In many years of our portfolio simulation, the rebalancing proceeds have been sufficient to meet living expenses and even top off depreciated positions. In other years, not so much, and our hypothetical retiree would need to turn to short-term reserves to supply living expenses. You can view the simulation in this spreadsheet (Microsoft Excel required) or this PDF.

The years 2014 and 2015 provide good illustrations of each of those environments. Eight of our portfolio's 10 holdings gained value in 2014, led by our total U.S. stock market index fund, which soared by more than 12%. Bonds also performed reasonably well, with both Harbor Bond and Loomis Sayles Bond kicking in a 5% return apiece. Those strong returns enabled us to meet our cash flow goal of $88,111 while also reinvesting in the international and commodities funds, which dropped in value. (To review, we arrived at the cash flow amount by taking an initial withdrawal of 4% from our $1.5 million portfolio in 2000 [$60,000], then inflation-adjusting that dollar amount annually. That's the system underpinning the oft-cited "4% rule" for in-retirement portfolio withdrawals.)

Performance wasn't nearly as strong in 2015, and the portfolio declined in value. Just half of our holdings made it into the black last year, and those returns were modest: Vanguard Wellesley Income was the portfolio's biggest gainer, with returns of just 1.28%. The core equity fund in the simulation, T. Rowe Price Equity Income, had a year to forget, with a nearly 7% loss. (Vanguard Dividend Growth, which is the recommended core equity position in my actual portfolio, would have performed better; as noted above, it doesn't have a long enough history as a diversified equity fund to be used in a simulation dating back to 2000.) Loomis Sayles Bond also had a weak year, and the commodities fund, while a small portion of the portfolio, continued to bleed red ink. Commodities prices have recovered in recent months, though it's anyone's guess as to whether that trend will persist.

Because our portfolio lost money in 2015, I turned to our short-term bond fund, which had gotten fat in better market years, to both supply the portfolio's cash flow and to top off depreciated positions. That illustrates the key virtue of the bucket strategy--even in lean market years, cash and other short-term reserves ensure stability of cash flows.

It's also worth noting that even with the 2015 losses, the portfolio's value at the outset of 2016 was more than $430,000 higher than where it started out, and it has also supplied roughly $1.19 million in cash flows. That's more a testament to strong stock and bond market performance that has prevailed during the 16 years of our stress test than it is to magic with bucketing or, for that matter, any particular prowess with asset allocation or security selection. It also illustrates that a 4% initial withdrawal, with inflation adjustments, is conservative and is designed to provide sustainable cash flows in a worst-case scenario market environment. (Most retirees would rather be safe than sorry when it comes to the topic of running out of money.) The 16 years in our stress test, although punctuated with two big bear markets, were decent.

Holdings Review

I've made just one notable alteration to the portfolio since inception, replacing

Note that Harbor Bond, Harbor Real Return, and Harbor Commodity Real Return are all subadvised by PIMCO, which has been in the spotlight over the past 18 months following Bill Gross' departure. Morningstar's analyst team downgraded Harbor Bond during this period, in part because it was directly affected by Gross' departure as well as broader concerns about personnel stability at the firm. Harbor Bond still earns a Bronze rating, however, so I left it in the portfolio. Harbor Commodity Real Return and Harbor Real Return don't currently receive Analyst Ratings, but they too remain in the portfolio. Their near-clones,

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