For retirees extracting cash flows from their portfolios, the year 2020 provided a vivid illustration of how capital appreciation often picks up where declining yields leave off.
Last year, bond yields were seemingly as low as they could go--the result of a Federal Reserve committed to keeping the economy from falling into a coronavirus-pandemic-induced depression. While dividends held relatively steady, cash payouts were barely positive and the yield on the Bloomberg Barclays Aggregate Bond Index ended the year just a hair over 1%.
Yet retirees who maintain balanced portfolios and aren’t wedded to subsisting on current income could find more than enough “income” elsewhere in their portfolios--namely, by harvesting appreciated equity and even bond assets. Such gainers were plentiful as 2020 wound down: Stocks rallied and declining yields stoked bond prices. That means that for retired investors employing a bucket strategy (or any strategy that features a balanced stock/bond mix), trimming those appreciated holdings and adding the proceeds to cash would provide them with enough assets to meet their cash flow needs in 2021, and perhaps a year or so beyond that, too.
To use a simple example of how this might work in practice, let’s assume a 65-year-old couple started retirement at the beginning of last year with a $1 million bucket portfolio, planning to withdraw $40,000 (4%) of their portfolio in year 1 of retirement. If they were using a bucket approach and a 60% equity/40% cash/bond portfolio, they’d start 2020 with $80,000 in cash (two years’ worth of portfolio withdrawals); $320,000 in bonds; and $600,000 in stocks. That’s the general allocation of my Aggressive Mutual Fund and ETF Bucket portfolios.
By year-end, though, their bucket 1 would be down to about $40,000, assuming they took their $40,000 withdrawal and earned just a modest yield on their cash over the past year. Meanwhile, bucket 2--mainly high-quality bonds--would have appreciated to nearly $340,000, assuming a 5% rate of return for that component of the portfolio. And the equity portfolio would have soared to about $700,000, assuming an eminently doable 15% total return from that portion of the portfolio in 2020. (Whether those stock and bond returns are repeatable in the years ahead is an open question!)
If our hypothetical retirees planned to periodically rebalance holdings to refill bucket 1, trimming bucket 3 back to its starting level of $600,000 (from $700,000) would supply more than two years’ worth of living expenses for bucket 1. That would give them a cushion so that stocks and even bonds could undergo an extended bout of volatility without any repercussions for their spending plan.
Of course, that’s a highly simplified example. But it’s still safe to say that bucket investors looking to raise cash and keep their portfolios’ risk levels in check have ample opportunities to do so following 2020, provided they maintained decent exposure to equities last year.
Not surprisingly, the most aggressively positioned of my bucket portfolios--the Aggressive Mutual Fund and ETF portfolios--performed best in 2020, with both gaining 10%-11%. Thanks to ample equity exposure and strong performance from most of their fixed-income holdings, the Conservative portfolios didn’t perform too shabbily, either, returning 7%-8%. Because the asset allocations and risk exposures of the Mutual Fund portfolios are quite similar to their ETF analogs, performance was similar, too. However, the ETF portfolios generally outperformed the mutual fund portfolios.
Aggressive Bucket Portfolio (Mutual Funds) 8%: Cash 8%: Fidelity Short-Term Bond FSHBX 10%: Harbor Bond HABDX 7%: Vanguard Short-Term Inflation-Protected Securities VTAPX 10%: Vanguard Wellesley Income VWIAX 10%: Vanguard Total Stock Market Index VTSAX 24%: Vanguard Dividend Appreciation VDADX 15%: American Funds International Growth & Income IGIFX 8%: Loomis Sayles Bond LSBDX
2020 Return: 9.58%
Moderate Bucket Portfolio (Mutual Funds) 10%: Cash 10%: Fidelity Short-Term Bond 5%: Fidelity Floating Rate High Income FFRHX 15%: Harbor Bond 10%: Vanguard Short-Term Inflation-Protected Securities 5%: Vanguard Wellesley Income 10%: Vanguard Total Stock Market Index 20%: Vanguard Dividend Appreciation 10%: American Funds International Growth & Income 5%: Loomis Sayles Bond
2020 Return: 8.84%
Conservative Bucket Portfolio (Mutual Funds) 12%: Cash 12%: Fidelity Short-Term Bond 5%: Fidelity Floating Rate High Income 20%: Harbor Bond 11%: Vanguard Short-Term Inflation-Protected Securities 5%: Vanguard Wellesley Income 23%: Vanguard Dividend Appreciation 7%: American Funds International Growth & Income 5%: Loomis Sayles Bond
2020 Return: 7.55%
Performance Recap Several of the same performance trends that prevailed in 2019 carried into 2020--namely, cash was a drag while large-cap U.S. equities reigned supreme.
Reprising its status in 2019, Vanguard Total Stock Market Index was the top-performing holding across the portfolios in 2020, gaining 21%. Core equity holding Vanguard Dividend Appreciation trailed the total market index by 5.5 percentage points. The main drawback for the dividend-growth-focused index fund was its underweight in technology stocks--it holds just 14% in the sector, whereas total stock index funds hold about one fourth of their assets in technology. Yet I’m comfortable with Dividend Appreciation as a core holding in the Bucket portfolios because its high-quality focus has generally helped it hold up better on the downside than the index and its Morningstar Category peers. Minimalist investors could reasonably obtain U.S. equity exposure through a total market index fund alone, whereas retirees who like to receive a bigger share of their cash flows from dividends might consider Vanguard High Yield Dividend Index VHYAX.
On the bond side, the high-quality holdings that populate bucket 2 in all of the portfolios performed exceptionally well in absolute terms. Linchpin bond holding Harbor Bond--a clone of Pimco Total Return--enjoyed a standout year relative to both its intermediate-term core-plus category peers as well as the Bloomberg Barclays Aggregate Index. That owes in in part to the Harbor fund’s exposure to longer-duration U.S. bonds in 2020’s declining-yield environment.
In contrast with their performance in 2019, however, the more credit-sensitive holdings in the portfolios struggled. While Loomis Sayles Bond and Fidelity Floating Rate High Income ended the year in the black, they experienced steep losses in the first-quarter pandemic-related market shock and spent much of the subsequent nine months clawing their way back.
As was the case in 2019, cash was the worst-performing holding in all of the portfolios last year. While bond investors enjoy capital appreciation as yields decline, cash investors don’t; their yield is their return. That yields are so very low today argues for investors not overdoing the cash component of their portfolios. At the same time, it’s worth remembering that cash is in place in the bucket portfolios not as a return engine but to provide steady cash flows if the stock or bond components of the portfolios falter. You don’t have to look too far back into the past for an example of when that was the case: In 2018, for example, cash was the best-performing holding in all of the model bucket portfolios.
Portfolio Changes: None. However, it's worth noting that longtime Loomis Sayles Bond manager Dan Fuss will step away from his management responsibilities in March of this year. Fuss will continue to serve as a special advisor to the firm's "Full Discretion" strategies, however. Morningstar analysts have maintained the fund's Silver rating, noting that the manager succession strategy has been thoughtful and playing out for more than a decade. Thus, I'm hanging onto it for these portfolios, but note its position in bucket 3; because of its volatility potential, it's best suited to investors with long time horizons.
Aggressive Bucket Portfolio (ETFs) 8%: Cash 7%: Vanguard Short-Term Bond ETF BSV 10%: Vanguard Short-Term Inflation-Protected Securities VTIP 13%: iShares Core Total USD Bond Market ETF IUSB 28%: Vanguard Dividend Appreciation Index ETF VIG 13%: Vanguard Total Stock Market ETF VTI 15%: Vanguard FTSE All-World ex-US ETF VEU 3%: Vanguard High-Yield Corporate VWEAX 3%: iShares JPM Morgan USD Emerging Markets Bond EMB
2020 Return: 10.90%
Moderate Bucket Portfolio (ETFs) 10%: Cash 7.5%: Vanguard Short-Term Bond Index ETF 12.5%: Vanguard Short-Term TIPS ETF 7.5%: Fidelity Floating Rate High Income FFRHX 15%: iShares Core Total USD Bond 22.5%: Vanguard Dividend Appreciation Index ETF 10%: Vanguard Total Stock Market ETF 10%: Vanguard FTSE All-World ex-US ETF 2.5%: Vanguard High-Yield Corporate 2.5%: iShares JP Morgan USD Em Markets Bond 2020 Return: 9.24%
Conservative Bucket Portfolio (ETFs) 12%: Cash 13%: Vanguard Short-Term Bond ETF 15%: Vanguard Short-Term Inflation-Protected Securities 20%: iShares Core Total U.S. Bond Market 6%: Fidelity Floating Rate High Income 21%: Vanguard Dividend Appreciation ETF 7%: Vanguard FTSE All-World ex-US ETF 3%: Vanguard High-Yield Corporate Bond 3%: iShares JPMorgan USD Emerg Markets Bond
2020 Return: 7.38%
Performance Recap Because their asset-class exposures are similar, the performance of these three ETF portfolios closely mirrors that of their mutual fund counterparts. However, the ETF portfolios have all outperformed their mutual fund counterparts over the past year.
As with the mutual fund portfolios, the Aggressive ETF bucket portfolio gained the most, thanks largely to its exposure to the total market index fund and Vanguard Dividend Appreciation. The Conservative portfolio relies exclusively on Vanguard Dividend Appreciation for its equity exposure and therefore missed out on the very strong performance of some of the names that paced the market last year, such as Apple AAPL, Microsoft MSFT, and Amazon AMZN.
On the fixed-income side, core holding iShares Core Total USD Bond Market delivered a robust 8% return, but it lagged Harbor Bond, the active core bond position in the mutual fund portfolios. As with the mutual fund portfolios, cash and short-term bond holdings performed less impressively, but they're in place largely to provide stability, not growth.
Portfolio Changes None.