(PUB) Morningstar FundInvestor

September 2013

Morningstar FundInvestor

17

For the purpose of back-testing our sample portfolio’s returns, we used the following system:

Take-Away 2: Maintenance Strategy Matters The back-testing of our bucket strategy also highlights the role that bucket maintenance plays in the portfo- lio’s performance and how many different variations there are to consider. The maintenance strategy featured here—which used rebalancing proceeds to top up the portfolio’s cash stake before adding to depressed positions—arguably reduced the portfolio’s total-return potential in exchange for keeping cash in the range of two years’ worth of living expenses. (In essence, it values safety and peace of mind more than growth potential.) An investor who’s more interested in generating high long-term total returns and less concerned about safety and liquidity, on the other hand, might take the opposite tack, plowing rebalancing proceeds into depressed positions and then topping up the cash stake. Alternatively, one might rebalance based on percentage variations relative to asset-allocation targets, rather than variations relative to initial posi- tion sizes, as featured here. (Note that if a retiree wishes to make his portfolio more conservative as it is drawn down, the rebalancing strategy would need to change to allow for larger cash and bond components.) Take-Away 3: More Complicated Than It Looks Our model portfolio is less complicated than most retirees’ situations, in that most people come into retirement with multiple accounts, both taxable and tax-sheltered; couples’ planning adds even more wrinkles. That means real-life bucket setup and main- tenance is going to be more complex than is the case for the single portfolio featured here, owing to asset-location and withdrawal-sequencing issues and the need to take required minimum distributions from tax-deferred accounts, among other consider- ations. That shouldn’t deter you from employing buck- ets in your own retirement distribution plan, but our sample portfolio arguably oversimplifies what it takes to implement such a system. œ Contact Christine Benz at christine.benz@morningstar.com

p Reinvest all dividends and capital gains. p Rebalance positions at the end of the calendar year if the position size exceeds 110% of its starting value in 2007 . p Use rebalancing proceeds from appreciated posi- tions to meet living expenses. p If rebalancing proceeds are insufficient to meet living expenses, withdraw cash from bucket 1 to meet planned living expenses. p If rebalancing proceeds exceed living-expense needs, use rebalancing proceeds to refill bucket 1 if lower than starting level ($ 120 , 000 ). p If rebalancing proceeds meet living expenses and bucket 1 is full, use rebalancing proceeds to add to positions that have declined the most (or appreci- ated the least) since 2007 . The Stress Test: Year by Year For a detailed look at the year-by-year results of our bucket stress test, you can download a spreadsheet on mfi.morningstar.com . I also included a synopsis of the portfolio’s performance in each calendar year, as well as the steps I took to maintain the portfolio. Take-Away 1: Diversification Proves Its Mettle Among the key conclusions from the exercise is that, even more than the bucket framework, holding and rebalancing a diversified portfolio in retirement can help provide decent performance and deliver a steady cash flow under a variety of market conditions. During the depths of the bear market, for example, rebal- ancing out of the portfolio’s appreciated stakes in high-quality bonds helped meet planned withdrawal amounts. Those rebalancing proceeds, plus cash withdrawals from bucket 1 , obviated the need to with- draw from equity assets while they were down. Main- taining a sizable equity stake, meanwhile, allowed the portfolio to rebound more than it would have if it were focused strictly on bonds and other income- producing assets, particularly as yields plummeted coming out of the financial crisis.