For Bucket Portfolios, 2019 Was a Layup, Not a Stress Test

The year 2019 wasn't much of a stress test for my bucket portfolios--or any other sane in-retirement portfolio strategy, for that matter. Instead, it was more like a layup.

Stocks soared last year and bonds enjoyed solid gains, too. That strong performance boosted the portfolio in the simulation over the $2 million mark, from its initial level of $1.5 million in 2000. It also supplied our hypothetical retirees with a cash flow of nearly $100,000 for the year. They started with a $60,000 withdrawal--4% of their original balance--in year 1 of the portfolio simulation 20 years ago, but annual 3% inflation adjustments have taken that value up steadily over the past two decades. Totaled up, those withdrawals account for another $1.6 million in appreciation, above and beyond the $500,000 in gains that are reflected in the ending balance. You can view the simulation in this spreadsheet (Microsoft Excel required).

A fantastic year like 2019 provides retirees with an opportunity to reset and recalibrate their portfolios in line with their goals. For my bucket portfolio “stress test,” I’m maintaining a conservative-trending asset allocation that peels back appreciated positions once they exceed their starting size by 10%. The net effect of that aggressive rebalancing system is that in strong market years like 2019, I’m trimming appreciated holdings and plumping up more conservative positions, especially short-term bonds.

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.

To be sure, over the 20 years of my portfolio simulation, my strategy of rigorously trimming appreciated securities and plowing the proceeds into conservative investments surely hurt raw returns relative to a portfolio with a static or increasing-equity allocation. After all, stocks have been extraordinarily good over the past decade, notwithstanding periodic market shocks (2000-02, 2007-09). Meanwhile, cash investments--the holdings in bucket 1--have been dead money; as yields have declined and stay low, the poor cash investor has had to settle for lower and lower yields. On the other hand, the cushion of cash and short-term bonds, a linchpin of the bucket strategy, would no doubt provide an intangible that’s not reflected in raw returns--peace of mind.

A Bucket Overview In a nutshell, the Bucket strategy enables retirees to customize their asset allocations based on their expected spending from the portfolio. Cash flow needs for the next one to two years (Bucket 1) are parked in the only asset that is guaranteed to not lose money over such a short time frame: cash instruments like money market funds and CDs. Cash flow needs for the next eight years are earmarked for high-quality bonds (Bucket 2); over the past 25 years, the Bloomberg Barclays Aggregate Index has generated positive returns in 100% of rolling three-year periods. The remainder of the portfolio (Bucket 3) goes into stocks and higher-risk assets like junk bonds; because the retiree holds at least 10 years' worth of cash flow needs in Buckets 1 and 2, the higher-risk assets aren't so risky after all. The S&P 500 has generated positive returns in more than 90% of rolling 10-year since 1989.

In the stress test of my aggressive mutual fund portfolio, I assumed a $1.5 million portfolio with a 4% initial withdrawal, translating into $60,000 in year 1 of retirement (2000 in my simulation). That withdrawal amount is then adjusted annually to account for inflation, but the retiree foregoes the inflation adjustment in years in which the portfolio loses value (like 2018).

The starting portfolio used in the simulation is as follows. Note that there are variations between these holdings and the ones featured in the actual Aggressive Mutual Fund Bucket portfolio. In some cases I had to use proxies in the simulation to account for varying inception dates and strategy changes. For example, Vanguard Dividend Appreciation 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 PRFDX 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 HAINX. I also swapped in Fidelity Short-Term Bond FSHBX in place of T. Rowe Price Short-Term Bond PRWBX when the latter was downgraded to a Neutral rating.

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

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

Bucket 3: $900,000 $400,000: T. Rowe Price Equity Income $200,000: Harbor International $100,000: Vanguard Total Stock Market Index VTSMX $125,000: Loomis Sayles Bond LSBRX $75,000: Pimco Commodity Real Return PCRAX

Performance Update All the holdings in the portfolio generated a positive return in 2019, but none better than the plain-vanilla total stock market index. Silver-rated T. Rowe Price Equity Income, which I used to stand in for Vanguard Dividend Appreciation in my simulation, performed respectably but not as well as the Vanguard fund, as holdings such as Wells Fargo WFC weighed on results. Vanguard Wellesley Income continued to demonstrate why it's among Morningstar readers' most-beloved holdings, gaining 16% even though it holds just one third of its assets in equities.

Because the portfolio gained in value last year, I gave our hypothetical retirees a small raise to account for inflation. I withdrew money from the short-term bond fund, which had grown large due to the maintenance regimen outlined below, to meet the hypothetical retiree's cash flow needs. I trimmed nearly every holding in the portfolio back to its starting value, plowing the money back into the short-term bond fund.

Maintenance Regimen Here are the details on the portfolio maintenance regimen I employed in the "stress test"; you can also see it reflected in the portfolio simulation.

• Withdraw 4% from the portfolio in year 1 (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 1 using rebalancing proceeds. Portfolio rebalanced annually if position sizes exceed 110% of their original size. (This leads to more rebalancing opportunities than would be the case with classic rebalancing.)
• If rebalancing proceeds are less than annual living expenses, pull the remainder of needed cash flow from T. Rowe Price Short-Term Bond in Bucket 2.
• 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.