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Testing the Bucket Approach to Retirement Portfolio Matters | Christine Benz

that a bucket portfolio started today will fare as well, particularly given rock-bottom bond yields and the fact that equity market valuations are nowhere near as attractive as they were following the 2008 market crash. Specific categories, such as the Treasury Infla- tion-Protected Securities in portfolio holding Harbor Real Return HARRX , appear to have limited upside potential today. The Starting Portfolio The starting portfolio is geared toward young retirees with an anticipated time horizon of 25 years. They will use a 4% withdrawal rate, with an annual infla- tion adjustment, which translates into a $ 60 , 000 withdrawal from their $ 1 . 5 million portfolio in the first year of retirement. They have a high risk tolerance. The sample portfolio features the following holdings in the following dollar amounts.

Using buckets to organize your retirement portfolio by time horizon has caught on because of the psycho- logical benefits. By maintaining a dedicated cash pool to draw upon for near-term living expenses—the linchpin of every bucket program—retirees can ride out fluctuations in the long-term portion of their port- folios. They can also switch on automatic withdrawals from their cash buckets to simulate a paycheck, and that reliable income stream can provide comfort in good markets and bad. Finally, a bucket strategy gets retirees away from what I consider to be an unhealthy form of mental accounting: focusing on income at the expense of total return. But does bucketing actually work in practice—does it meet a retiree’s cash needs while also generating a satisfactory level of return? I began creating sample bucket retirement portfo- lios—consisting of both traditional mutual funds and exchange-traded funds—just last year, so they don’t have a sufficiently long track record to observe. But at the risk of being accused of data-mining, I took a look back at one of my bucket portfolios to see how it would have performed during the stress test of the 2008 financial crisis and in the subsequent equity market recovery. I tested the most aggressively posi- tioned of the model bucket portfolios—the one geared toward retirees with 25 -year time horizons. That portfolio’s heavy equity weighting has been a big help recently as stocks have rallied, but its equity- heavy stance also left it with a big hole to claw its way out of in 2008 . The exercise yielded some encouraging results during this admittedly arbitrary time period. The headline is that at the end of 2012 , the value of the aggressive bucket portfolio was ahead of the starting value of the portfolio, even though our fictitious retiree was also withdrawing 4% of the portfolio, adjusted for inflation, per year. Of course, there’s no guarantee

Welcome to our new feature, Portfolio Matters, by Christine Benz, Morningstar’s director of personal finance. We’re thrilled to have Christine help you manage the port- folio challenges that you face each month. Christine will address personal finance issues with prac- tical solutions throughout the year.

Bucket 1: $120,000 $120,000

Cash (In my original portfolio, I used cash plus PIMCO Enhanced Short Maturity ETF MINT for bucket 1. But because the PIMCO fund has only been around since late 2009, I used Vanguard Prime Money Market VMMXX as a proxy in the return simulation.)

Bucket 2: $480,000 $130,000

T. Rowe Price Short-Term Bond PRWBX

$150,000 $100,000 $100,000

Harbor Bond HABDX

Harbor Real Return HARRX

Vanguard Wellesley Income VWINX

Bucket 3: $900,000 $400,000

Vanguard Dividend Growth VDIGX

$200,000 $100,000 $125,000

Harbor International HAINX

Vanguard Total Stock Market Index VTSMX

Loomis Sayles Bond LSBDX

$75,000

Harbor Commodity Real Return HACMX (Note that this fund wasn’t launched until 2008, so I’ve used near-clone PIMCO Commodity Real Return PCRAX in its place in the return simulation.)

Cash Flow and Rebalancing Rules One of the keys to making a bucketing strategy work is to have a plan for bucket maintenance: how you’ll refill bucket 1 if it becomes depleted and how you’ll manage rebalancing.