One of your plans’ participants is retiring, and she’s considering rolling over her 401(k) balance to your wealth management operation. She’s had solid results with the plan’s target date fund, and she understands the case for diversified asset allocation and an ongoing equity exposure in her portfolio after she stops working.
So far, so good, but when you meet with her to discuss your retirement-portfolio management process in more detail, you begin to sense some serious concern about political environment, trade wars, market volatility and other external factors. "I didn’t worry too much about those risks when I was working because I could rely on my salary to cover expenses," she explains. But if we have another bear market like 2008, what will happen to the income from my portfolio?
It’s an understandable concern. Plan participants approaching retirement and those who have recently retired naturally worry about sequence-of-returns risk, even if they don’t know that technical term. They saw what happened to the accounts of some investors who retired just before and during the 2008 bear market and they want to avoid the same fate. It’s not just about surviving major bear markets, of course--it’s a lifestyle concern. If the retiree has a target annual withdrawal rate of say, 3 to 4 percent, and the markets experience flat or negative returns for several consecutive years, the cumulative drawdown could reduce future portfolio distributions significantly.
Buckets to the Rescue?
For an investor like this, the bucket approach to retirement portfolio design directly addresses these issues. Retirees set aside several years’ worth of anticipated withdrawals in guaranteed cash accounts and invest their portfolio’s remaining balance more aggressively. In a three-bucket model, for example, the first bucket could hold Treasury bills or insured bank accounts in an amount that covers two years’ projected expenses. The second bucket could have intermediate-term Treasury bonds and the third bucket would hold a diversified equities portfolio to focus on growth.
This approach has an intuitive and comforting appeal: Regardless of how the investment markets perform at any time over the subsequent two years, the retiree’s living expenses are covered. Using the past 30 years as a reference, two years’ funds should suffice to ride out much of the markets’ short-term gyrations. There are additional benefits: The retiree won’t be forced to liquidate investments at depressed prices to cover living expenses and there should be a reduced risk of panic selling.
Bucket Research
A retiree’s financial peace of mind is important and some clients likely will sleep better using buckets instead of the usual total-return model. But advisors should understand the bucket approach’s limitations and its potential costs. Two research findings in particular are worth reading about these drawbacks. The first is a blog post published by advisor Michael Kitces in late 2014, “Managing Sequence of Return Risk with Bucket Strategies versus a Total Return Rebalancing Approach.”
Kitces examines the sequence of returns risk and liquidation decision rules that govern a hypothetical, standard three-bucket portfolio from which the investor takes a 4 percent annual withdrawal and the portfolio is rebalanced at the start of each year. He also considers how the practice of periodic rebalancing influences sequence of returns risk management under a total return regime.
Periodic rebalancing is the key in both approaches, he emphasizes. Bucket strategies and total return approaches will produce the same result, provided they are implemented with rebalancing. He concludes: “And if clients are more comfortable with bucketing strategies— if only because they appeal more naturally to our tendency towards mental accounting—then so much the better. But just be certain to recognize that while it may be more effective to explain portfolios as a series of buckets to clients, be cautious not to allow the asset allocation to become distorted by trying to manage the portfolio that way!”
An October 2018 paper from Professor Javier Estrada, “The Bucket Approach for Retirement: A Suboptimal Behavioral Trick?” is more critical of bucketing. Estrada evaluates three bucketing strategies versus 11 static investment strategies using multiple metrics of performance assessment. He takes a global perspective, examining returns in 21 countries for the 115-year period between 1900 and 2014. His findings: “Ultimately, the evidence shows that a bucket approach underperforms static strategies, and it does so based on four different ways of assessing performance.”
Estrada maintains that advisors should counsel clients that bucketing’s benefits are not cost-free. He concludes: “And they should attempt to convince retirees that however plausible, comforting, and easy to implement the bucket approach may be, a static strategy with an appropriate asset allocation would be just as easy to implement and would ultimately make them better off.”