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Investing Specialists

How Does the Bucket Strategy Work in Practice?

Equity holdings perform well, while inflation hedges lag.

If you hear an investment professional say "back-test," that should usually be your cue to run in the other direction. 

After all, with the benefit of hindsight, it's not hard to figure out precisely which factors would have predicted the market's direction and create back-tests to illustrate how smart you are. But whether those same factors will be predictive on a forward-looking basis is another story. (Morningstar's John Rekenthaler discusses the perils of back-testing in this article.) 

Yet, back-testing is essentially what I've done with the "stress tests" of my model bucket portfolios. Before you get out the pitchforks, I'll clarify that the stress tests weren't designed to show off my asset-allocation or fund-picking expertise. My model bucket portfolios for retirement all take a plain-vanilla, strategic approach to apportioning assets among stocks, bonds, and cash. And while the fund picks are drawn from Morningstar's list of highly rated funds, I've always said that investors should feel free to swap in their own favorite funds in place of the portfolio's holdings. 

Rather, the goal of the stress tests was to answer two key questions. First, how would the bucket approach have worked during the two bear markets that punctuated the previous decade--2000-02 and 2007-09? Would a retiree have been able to meet his or her cash flow needs while leaving the portfolio's long-term holdings undisturbed for a rebound? And second, what are the logistics of bucketing--that is, how does the long-term portfolio create enough cash flow to live on? 

My first stress test looked back at how one of my model bucket portfolios--and the bucket strategy in general--would have performed during the financial crisis. Later stress tests went back even further, to the bursting of the dotcom bubble, and also incorporated variations on the portfolios themselves, including a highly simplified bucket portfolio. 

A year later, it's time to revisit the portfolio, to incorporate 2013 results and to demonstrate the logistics of the bucket strategy in a rising-market environment.

Revisiting Assumptions, Reviewing the Buckets
The central idea of the bucket strategy is that a retiree maintains a cash pool to meet near-term living expenses alongside a total-return portfolio. Having liquid reserves to meet living expenses can help a retiree cope psychologically with the idea of having most of his or her assets in more volatile, but higher-returning, asset types. As the cash bucket becomes depleted, the retiree fills it with income and dividend distributions and/or rebalancing proceeds harvested from the total-return portfolio. 

In my model bucket portfolios, I've segmented the total-return portfolio into two separate buckets: an intermediate-term piece--mainly bond funds--and a longer-term piece dominated by equity funds. Holding both an intermediate- and long-term bucket helps facilitate rebalancing, and the bond-heavy bucket can also provide next-line reserves should bucket 1 (cash) run dry and neither stocks nor bonds have appreciated enough to warrant rebalancing. 

For the portfolio featured in the stress test, I assumed a 65-year-old couple with a $1.5 million portfolio. Because they have a fairly long time horizon, the portfolio featured an equity weighting of roughly 50% of assets; the remainder of the portfolio is in bonds and cash. 

Here's an overview of the portfolio: 

Bucket 1: $120,000
$120,000: Cash (In previous versions of the portfolio I used cash substitutes like  PIMCO Enhanced Short Maturity ETF (MINT), but online savings accounts have higher yields than such vehicles today.) 

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

Bucket 3: $900,000
$400,000:  Vanguard Dividend Growth (VDIGX) (Note that the stress test features  T. Rowe Price Equity Income (PRFDX) instead of this fund, because the Vanguard fund had a different mandate in 2000, the start date of the stress test.)
$200,000:  Harbor International (HAINX)
$100,000:  Vanguard Total Stock Market Index (VTSMX)
$125,000:  Loomis Sayles Bond (LSBRX)
$75,000:  Harbor Commodity Real Return (Because this fund didn't exist in 2000, the start of the stress test, we've swapped in Oppenheimer Commodity Strategy Real Return instead.) 

Cash Flow and Rebalancing Rules
Central to making a bucket strategy work is periodically shaking money out of the longer-term buckets to re-fill bucket one for the next year's living expenses. Retirees can employ different strategies to create that cash flow. They can plow income and dividend distributions directly into bucket one, they can use rebalancing proceeds to re-fill bucket one, or they can employ a combination of these strategies. For the purpose of the stress test, 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 forego inflation adjustment in years in which the portfolio loses value.
• Reinvest all dividends and capital gains.
• Re-fill bucket one using rebalancing proceeds. Portfolio rebalanced annually if position sizes exceeds 110% of their original size.
• 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 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.

Strong Markets Lift Most (But Not All) Boats
Although the portfolio has experienced two major bear markets since 2000, its results from 2000 through 2013 were encouraging. Not only did the bucket portfolio meet our cash flow needs--an initial withdrawal of 4% of the portfolio's balance, adjusted for inflation annually--but it also ended 2013 with a balance more than $500,000 higher than the starting balance in 2000. 

The year 2013 was particularly kind to the portfolio, thanks to tremendous appreciation in the equity portion. Although our equity portfolio's value bias and global diversification held it back relative to a total U.S. stock market index tracker, the appreciated equity holdings provided ample cash for living expenses and also allowed for reinvestment back into the long-term portion of the portfolio. 

In particular, we topped up our holdings in inflation-fighting investments coming into 2014. Both our inflation-protected bond fund and our commodity holding slumped in value last year due to benign inflation and slack demand for inflation hedges, so we added to our positions in those holdings. (Note that the two inflation-fighting funds in our model portfolio, Harbor Real Return and Harbor Commodity Real Return, weren't around in 2000, so we used PIMCO Real Return and Oppenheimer Commodity Strategy Total Return, respectively, as proxies.) Inflation-protected securities are putting up great returns so far in 2014; commodities, not so much.

Rebalancing Strategy Crucial
Also noteworthy is that the rebalancing rules we're employing--outlined above--have had the net effect of making the portfolio more conservative over time. That's because we're trimming each position back to its starting value once it exceeds 110% of its original size; proceeds that aren't needed to re-fill bucket 1 get plowed into depreciated holdings and our portfolio's short-term bond holding. As we've trimmed the portfolio's equity positions over the past five years, its cash and short-term bond positions have grown, and the total portfolio now has about 60% in bonds and cash. 

Retirees who want to maintain a more-or-less static asset allocation during retirement could take a different--and more conventional--rebalancing tack. Rather than rebalancing individual positions back to their starting values, they could trim positions only when their total exposure to an asset class exceeds a percentage of the target--say, five or 10 percentage points. That strategy will tend to lead to less-frequent rebalancing opportunities (meaning fewer chances to harvest winning holdings for living expenses) but will also lead to better results in strong equity markets.

For a detailed look at the year-by-year results of our bucket stress test, you can download this spreadsheet (Microsoft Excel required) or this PDF.

See More Articles by Christine Benz

Christine Benz does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.