Every retiree wants to build a resilient retirement portfolio. One of the most important parts of such a portfolio is durability. Durability allows a retirement portfolio to sustain increasing annual withdrawals without becoming depleted before the owner turns 90 (assuming a retirement age of 65). A durable portfolio outlasts the retiree.

Let's compare four different retirement portfolios: 100% bonds; 60% bonds/40% stock; 60% stock/40% bonds; and a multi-asset portfolio that invests equally in seven different asset classes (large U.S. stock; small U.S. stock; non-U.S. stock; real estate; commodities; U.S. bonds; cash). Over a 40-year period, which one has the greatest durability? But before we analyze the portfolios during the distribution phase, let's first take a look at how they performed during the accumulation phase.

A PARTY OF FOUR

The obvious appeal of a 100% U.S. bond portfolio is that it nearly always has positive nominal returns (before considering the impact of inflation). As a result, an all-bond portfolio has very low volatility of return (as measured by standard deviation). Over the 40-year period from Jan. 1, 1970 to Dec. 31, 2009, an all-bond portfolio (using the performance of the Barclays Capital Aggregate Bond Index) had an annualized return of 8.3%, an annual standard deviation of 6.73% and a worst three-year cumulative return of 6.2%. This assumes a single lump sum investment on Jan. 1, 1970, and no additional investments or withdrawals.

A 40/60 portfolio (40% large U.S. stock, 60% aggregate bonds) with annual rebalancing had a higher 40-year annualized return by 100 basis points, but also produced more volatility. Moreover, its worst three-year cumulative percentage return during this period was -0.4%. By comparison, the all-bond portfolio never had a three-year period (and there were 38 rolling three-year periods between 1970 and 2009) during which it experienced a cumulative percentage loss.

Compared with the 40/60 portfolio, a 60/40 portfolio (60% large U.S. stock and 40% aggregate bonds) that was annually rebalanced produced a slightly higher return of 9.7%, but with an increase in standard deviation to 11.87%. The worst-case three-year cumulative return increased dramatically to -13.3%.

A multi-asset portfolio with equal allocations to seven different asset classes (annually rebalanced) had a 40-year annualized return of 10.5% and a slightly lower standard deviation of 10.59% compared with the classic 60/40 portfolio. The worst three-year cumulative return of -13.3% was the same as the 60/40 portfolio. Compared with the standard 60/40 portfolio, a multi-asset portfolio grew money faster and with comparable risk.

Over the 40-year period of this study, the S&P 500 served as a proxy for the performance of large-cap U.S. equities, while the Ibbotson Small Companies Index, from 1970-1978, and the Russell 2000 Index, from 1979-2009, captured the performance of small-cap U.S. equities. The Morgan Stanley Capital International EAFE Index (Europe, Australasia, Far East) tracked the performance of non-U.S. equities. U.S. bonds were represented by the Ibbotson Intermediate Term Bond Index from 1970-75 and the Barclays Capital Aggregate Bond index from 1976-2007.

Three-month Treasury bills represented the historical performance of cash. The performance of real estate was measured by using the annual returns of the NAREIT Index (returns for 1970 and 1971 were regression-based estimates, inasmuch as the NAREIT (National Association of Real Estate Investment Trusts) Index did not provide annual returns until 1972). Finally, the Goldman Sachs Commodities Index (GSCI) tracked the historical performance of commodities. As of Feb. 6, 2007, the GSCI became known as the S&P GSCI Commodity Index. Raw data for this study came from Morningstar Principia.

TESTING DURABILITY

The results reported above are for portfolios in the accumulation phase. We'll now focus on how these four portfolios behaved when money was being systematically withdrawn during the distribution phase of retirement.

We began with a retirement portfolio with a starting balance of $100,000. The initial withdrawal at the end of the first year was 5% of the starting portfolio balance (in this case, $5,000). The annual increase in the cash withdrawal was 3% to account for annual inflation (or cost-of-living adjustment). Thus, the second-year withdrawal was $5,150, the third-year withdrawal was $5,305 and so forth.

The starting balance of the retirement portfolio is immaterial because it doesn't affect durability. The starting balance only affects the amount of the annual withdrawal, which may or may not be adequate for the retiree.

The durability analysis that follows represents the historical performance of the four types of retirement portfolios over 16 rolling 25-year periods. The first 25-year period (representing age 65 to age 90) was from 1970-1994, the second was from 1971-1995 and so on.

As shown in "Measuring Durability" (see left), the multi-asset portfolio had the largest median balance over the 16 different 25-year distribution periods where money was being withdrawn annually. Importantly, the average worst-case three-year return over the 16 different 25-year periods for the multi-asset portfolio was a positive 2%. By comparison, the standard 60/40 portfolio had an average worst-case three-year cumulative return of -12.4%.