Investing Specialists

How Did the Bucket Strategy Work in 2018?

Christine Benz

A whole lotta red ink.

That's what many investors see when they look at their portfolio's results following 2018. While stocks have enjoyed their strongest January start since (ummm) 1987, last year's tumultuous market provided investors with few places to hide. Most core U.S. stocks and bond funds incurred single-digit losses for the year, but even small drops can be unnerving when you're retired.

What made 2018 especially painful is that neither stocks nor bonds impressed. Bond yields rose, leading the Barclays Bloomberg Aggregate Index to post just a tiny gain for the year, but many bond funds endured losses. Stocks, meanwhile, underwent a punishing sell-off in the last few months of the year. The U.S. market lost about 5%, while most foreign-stock funds endured losses in the neighborhood of 14% to 15%.

The Bucket approach to retirement portfolios, which calls for holding a cash bucket alongside a long-term portfolio, is designed with such an environment in mind. In upward-trending markets, cash is a drag on returns. But holding a cash cushion of one to two years' worth of living expenses helps protect against having to withdraw from long-term holdings after they've taken a dip (or worse).

The question is, would an actual Bucket portfolio have delivered on that promise last year? And importantly, how would a retiree maintain a Bucket portfolio after a year like 2018? When the cash bucket needs topping up, what's the best way to refill it in a year when most portfolio holdings posted a loss?

Cash Has a 'Moment'
I decided to explore those questions with my Model Bucket Portfolios, using the Aggressive Mutual Fund Bucket Portfolio as the base case. (I'll do a more thorough performance discussion of the mutual fund and ETF portfolios over the next month, as well as update my Bucket portfolio "stress test" stretching back to the year 2000.) The Aggressive Mutual Fund Bucket portfolio features an 8% cash stake, roughly a third of assets in a diversified bond portfolio, and the remainder in a global equity portfolio. I arrived at the 8% cash position for the model portfolios by assuming a 4% initial withdrawal rate (4% times two years' worth of portfolio withdrawals), but urge investors to customize their own allocations based on their spending needs.  

All told, the Aggressive Bucket Portfolio lost 3.38% last year.  Vanguard Dividend Appreciation (VDADX), the largest single position in the portfolio, admirably held its ground and is partly responsible for the Bucket portfolio's strong performance relative to those benchmarks; its 2% 2018 loss put it in the top decile among large-cap blend funds. I like the fund for retiree portfolios precisely for its showing in years like 2018: Thanks to its focus on companies with a history of increasing their dividends, it’s concentrated in reliable, financially healthy firms that have historically held up well on the downside.  Vanguard Total Stock Mkt Idx Adm (VTSAX) and  American Funds International Growth & Income (IGIFX), which together hold about a fourth of the assets in the portfolio, were the Bucket portfolio's worst performers, losing 5% and 14%, respectively.

On the fixed-income side, the core bond holding in the portfolio,  Harbor Bond (HABDX), posted a small loss, though it finished the year in the top half of the intermediate-term bond group. Lower-quality bonds generally underperformed high-quality ones last year, so it's not surprising that  Loomis Sayles Bond (LSBRX), a multisector bond fund, was the worst-performing bond holding in the portfolio, losing about 3%. Meanwhile, as higher-quality and short-duration bonds performed well, so did tamer holdings like  Fidelity Short-Term Bond (FSHBX) and  Vanguard Short-Term Inflation-Protected Bond (VTAPX).  Vanguard Wellesley Income (VWINX), predictably, posted returns that fell between stocks' and bonds' last year.

While some of the bond holdings pitched in very modest gains, the real standout in the portfolio last year was cash, gaining almost 2%. (I use Vanguard Prime Money Market (VMMXX) as my cash proxy.) While cash is reliable ballast, it can sometimes be overshadowed by bonds in periods of equity-market weakness. Bond yields tend to be higher on an absolute basis, and rough equity markets can drive up demand for bonds, giving bond-fund investors a capital appreciation boost. But rising interest rates were a headwind for bonds for much of last year, while cash investors don't have to contend with rate-related shocks to principal.

Maintenance Issues
So what’s next for Bucket investors following 2018? The answer depends on the retiree's own strategy: how large a cash cushion she's maintaining, what approach she's taking to extracting cash from her portfolio on an ongoing basis (income, rebalancing, or a combination), and how she's managing her asset allocation. (This article does a deeper dive into these questions.)

For a retiree who's maintaining two years' worth of portfolio withdrawals in cash and employing a laissez-faire approach to tweaking asset allocation, doing nothing is probably the right course. (The ability to do nothing and leave long-term holdings untouched in such instances is one reason I favor holding two years' worth of portfolio withdrawals rather than just one.) She'd have another year's worth of portfolio withdrawals left, and last year's market volatility wouldn't have altered her portfolio's basic stock/bond allocation enough to warrant a rebalancing. She could take a look at her suballocations, however, as her foreign stock weighting may well be lighter than she intended following 2018's slump.

Retirees who are running with tighter cash allocations of just one year's worth of portfolio withdrawals, however, can't sit on their hands; they'll need to take action to identify cash flow sources for this year. The good news is that today, retirees employing an opportunistic bucket strategy can find more than half of their cash-flow needs through current income without going out on a (risky) limb for yield. Whereas the Aggressive Mutual Fund Bucket Portfolio yielded about 1.9% in September 2017, its yield popped up to 2.33% last year. That means that a retiree seeking a 4% overall withdrawal from his or portfolio can pick up more than half of that amount through income distributions alone. A more income-centric portfolio--one featuring a fund like  Vanguard High Dividend Yield (VHDYX) in lieu of Vanguard Dividend Appreciation, for example--could boost yield into the 3% range or above. Remaining cash-flow needs could be drawn from short-term bond holdings; those holdings would ideally be topped back up when other portions of the portfolio post meaningful gains.

Christine Benz does not own shares in any of the securities mentioned above. Find out about Morningstar's editorial policies.