A bucket portfolio stress test

I began creating sample bucket retirement portfolios -- consisting of both traditional mutual funds and exchange-traded funds – in 2012, 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 positioned 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 2013, 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 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 inflation-protected bonds in portfolio holding TD Real Return Bond  , appear to have limited upside potential today.

The starting portfolio

The starting portfolio, featured in depth in this article, is geared toward young retirees with an anticipated time horizon of 25 years. They will use a 4% withdrawal rate, with an annual inflation 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.

Bucket 1: $120,000

• $60,000: Cash (A preferred solution for this portion would be a no-fee, high-interest savings account, but since there is no benchmark that measures historical rates, we used the CIBC WM 91-Day Treasury Bill return as a proxy for cash.)
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• $60,000: TD Short Term Bond - I

Bucket 2: $480,000

• $130,000: TD Short Term Bond - I
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• $150,000: PH&N Bond Sr D  
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• $100,000: TD Real Return Bond - I  
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• $100,000: Steadyhand Income  

Bucket 3: $900,000

• $400,000: RBC North American Value Sr D  
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• $200,000: Mawer International Equity   (Note that in the original article I used CI Signature Select Global, but that fund wasn't launched until 2010, so I used the Mawer fund -- the only medalist international equity fund with a long enough history -- in its place in the return simulation.)
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• $100,000: CI Canadian Investment
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• $125,000: PH&N High Yield Bond Sr D  
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• $75,000: TD Real Return Bond - I  

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.

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

• Reinvest all dividends and capital gains.
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• Rebalance positions at the end of the calendar year if the position size exceeds 110% of its starting value in 2008.
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• Use rebalancing proceeds from appreciated positions to meet living expenses.
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• If rebalancing proceeds are insufficient to meet living expenses, withdraw cash from bucket 1 to meet planned living expenses.
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• If rebalancing proceeds exceed living-expense needs, use to refill bucket 1 if lower than starting level ($120,000).
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• If rebalancing proceeds meet living expenses and bucket 1 is full, use rebalancing proceeds to add to positions that have declined the most (or appreciated 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 this spreadsheet (Microsoft Excel required). What follows is a synopsis of the portfolio's performance in each calendar year as well as the steps I took to maintain the portfolio.

2008

Starting Portfolio Balance: 1,500,000
Ending Portfolio Balance: $1,330,025
Amount Withdrawn: $60,000
Owing to routs in the equity markets, the portfolio sheds $170,000 of its value during the worst year of the financial crisis. High-quality and short-term bonds are the only bright spots, but their gains are not enough to trigger a rebalancing, and the desired $60,000 distribution has to be financed entirely from bucket 1. Three of our holdings lost more than 10% of their value, but since bucket 1 has already been depleted, there is no money to refurbish those holdings.

2009

Starting Portfolio Balance: $1,270,025
Ending Portfolio Balance: 1,508,246
Amount Withdrawn: $61,800
Stocks bounce back strongly in 2009, and bonds also generate healthy gains as the U.S. Federal Reserve Bank embarks upon its quantitative easing campaign. (The only casualty? The cash position, whose yield shrivels to next to nothing.) Our main equity holding, RBC North American Value, has come back above its initial position size, but Mawer International Equity and CI Canadian Investment remain well below. All our bond funds surpassed the 10% threshold above their initial positions, so proceeds from the rebalancing of these positions allow us to meet living expenses of $61,800 (our original $60,000 distribution plus a 3% inflation boost) and rebuild most of the cash stake.

2010

Starting Portfolio Balance: $1,446,446
Ending Portfolio Balance: $1,593,790
Amount Withdrawn: $63,654
Owing to strong returns across the board, our portfolio ends the year at a higher level than when we started. Lightening up holdings in RBC North American Value, Steadyhand Income and PH&N High Yield Bond, which have appreciated more than 10% from their initial values, allows us to meet our desired living expenses of $63,654 and fully top-up the cash bucket; We are even left with an $10,959 surplus, which we allocate to our one remaining laggard, Mawer International Equity.

2011

Starting Portfolio Balance: $1,530,136
Ending Portfolio Balance: $1,554,279
Amount Withdrawn: $65,564
Our three stock funds posted losses owing to the debt situation in Europe, but our bond funds produced decent gains, allowing the overall portfolio to have a positive year. Pruning gains from strong performers TD Real Return Bond and PH&N Bond, both of which hit our rebalancing target, provide ample income for living expenses. A small surplus of $2,223 is allocated to Mawer International Equity, which continues to lag and has once again dropped below 90% of its original value. There is no need to touch bucket 1.

2012

Starting Portfolio Balance: $1,488,716
Ending Portfolio Balance: $1,613,581
Amount Withdrawn: $67,531
All of the major asset classes enjoy robust gains. Two of our holdings -- Steadyhand Income and PH&N High Yield Bond -- hit our rebalancing target. However, the rebalancing proceeds aren't enough to meet living expenses, so we need to tap our cash account for more than $31,000. Investors can use their judgment here, since our two largest equity holdings are above their targets by more than $55,000 but their surpluses fall just shy of the 10% mark. You could sell some of these holdings to make up for the $31,000 shortfall if you prefer not to withdraw cash, but I decided to stick to rules.

2013

Starting Portfolio Balance: $1,546,051
Ending Portfolio Balance: $1,713,280
Amount Withdrawn: $69,556
This was a spectacular year for equity markets, and our equity funds all gained more than 20%. TD Real Return Bond was the only real blemish, and PH&N Bond suffered a modest loss, but overall the gains were so strong that even after withdrawing our living expenses amount, we are left with a six-digit surplus. Rather than get into complicated calculations to reallocate the money, I simply reconstituted the portfolio in the original proportions but with the higher amount. All our positions are now slightly higher than when we started in 2008, and things are looking good.

Takeaway 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. When equity markets suffered a setback in 2011, for example, rebalancing out of the portfolio's appreciated stakes in bonds helped meet planned withdrawal amounts. Those rebalancing proceeds obviated the need to withdraw from equity assets while they were down. Maintaining a sizable equity stake following the crash of 2008, 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.

Takeaway 2: Maintenance strategy matters--a lot

The back-testing of our bucket strategy also highlights the role that bucket maintenance plays in the portfolio'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, beefing up depressed positions before topping up the cash stake.

Takeaway 3: It's 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 maintenance 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 considerations. That shouldn't deter you from employing buckets in your own retirement distribution plan, but our sample portfolio arguably oversimplifies what it takes to implement such a system. We'll be discussing additional aspects of bucket setup and maintenance in future articles.

--With files from Morningstar.ca site editor Christian Charest