Theory vs. Reality: The Retirement Planning Bucket Strategy
By Scott Oeth, July 24, 2019
“There’s a hole in my bucket, dear Liza, dear Liza…”
Is it possible in theory for a financial strategy to sound great and feel good, but in reality be a poor practice?
The popular “bucket strategy” for retirement portfolio cash flows is one such example. The idea is simple (part of its power!): break your portfolio’s holdings into different “buckets” to match future time segments.
While there is not one definitive bucket strategy process, I’ve typically seen two or three buckets mapped out. One bucket holds “safe and stable” holdings for near-term spending needs, a second bucket holds investments that are a step up on the expected risk and return spectrum for mid-term spending, and a final bucket holds the highest expected return assets (typically stocks), which are also the most volatile, for long-term spending needs. Depending on the exact bucket mechanism employed, as the retiree spends funds in the near-term buckets, those buckets are then periodically reloaded with dollars coming from the longer-term buckets.
At first glance, the bucket strategy seems to makes sense. There will always be at least one bucket of safe and stable investments for the retiree to use during times when the market falls. This adds a feeling of security during those inevitable bad stock market periods. It also allows retirees to remain confident that they can keep their stocks invested in the other buckets of higher-return and greater risk assets as they wait for the stock market’s equally inevitable recovery.
“…the general consensus is that there is no reason to believe that time segmentation [aka “Bucket Strategy”] is a uniquely better way to invest. To be a better investment strategy, it would need to be able to reduce sequence risk in a unique way relative to total-return portfolios with the same asset allocation. ”
— Wade Pfau, PhD, CFA | “How Much Can I Spend in Retirement,” p. 287
In reality, however, there are problems with the bucket strategy. As a Certified Financial Planner™ Practitioner, and having been a long-time university CFP instructor, I work to stay on top of the professional and academic research on retirement planning.
Javier Estrada, a finance professor at IESE Business School in Spain, recently did an academic deep dive into buckets in his research paper, “The Bucket Approach to Retirement: A Suboptimal Behavioral Trick?” and concluded that buckets are indeed suboptimal. So, where are the holes in the bucket strategy?
- Returns flowing downhill. In pure bucket strategies, there is a mandate to move assets from stocks to bonds and then cash over time, but not the other way around. Being unable to move money back into stocks causes investors to miss out on a huge portfolio management opportunity (the silver lining in a bear market): the ability to buy stocks cheaply during down markets! Rebalancing the entire retirement portfolio includes the gutsy and proven step of buying stocks during down markets. With most bucket approaches, cash and bonds are reloaded as they are spent or when stocks rise, but the investor misses out on the rebalancing benefit of buying depressed stocks and capturing their eventual rebound because that element is not included in a typical bucket strategy.
- Too cautious, too soon. To fill the stable near-term bucket, many bucket strategies force dollars into cash or low-yielding bonds too soon. The amount of cash and short-term bonds needed in a portfolio is, of course, a judgement call, but the bucket strategies I’ve witnessed typically hold more of these low-yielding types of assets than comparable “total return” asset allocation portfolios designed for retirees in similar positions. This scenario creates a “cash drag” on portfolio performance that can take a big bite out of returns over the course of a decades-long retirement.
- Poorly-designed “in-house” bucket models. From what I’ve seen, most investors—both professionals and individuals—who choose a bucket approach use some type of homemade spreadsheet to model their bucket portfolios. Unfortunately, these spreadsheets may contain critical flaws.
In one egregious example, I saw a financial advisory firm using a “Probability of Success” number on their “pensionitized” bucket models. After repeatedly questioning the inputs on the “Probability of Success,” I was told that these inputs were faux Monte-Carlo Analysis numbers that had simply been pulled from thin air!
In another example, a bucket model did not adjust the rate of return applied to the portfolio to account for the migration to bonds and cash over time. In effect, the model was showing 80-year-old retirees earning the returns of an “80/20” stock-bond portfolio, but they thought they were seeing a plan showing them owning a much more conservative investment mix! Returns were grossly overstated and risk was grossly understated.
“So fix it, dear Henry”
So, is the bucket strategy all bad? Well, not entirely. I like the concept. It helps investors understand the components of their portfolio, think long-term, and, crucially, it helps them stay invested and stick with a reasonable (even if sub-optimal) plan during market crashes. Down markets are all too often times of panic for investors, who then run for the exit, sell their holdings at a loss, and miss the market’s inevitable rebound. This is a destructive pattern, and if a buckets strategy helps prevent that type of self-destructive behavior, that’s a win! I don’t begin with a bucket approach with my clients, but at times, I do find it to be a useful way to explain the purpose of portfolio components.
A Bucket Strategy Alternative
Is there a better approach to portfolio cash flow in retirement than the bucket strategy? I think so.
- Run financial planning projections. Test the viability of different portfolio spending levels through retirement, as well as the long-term returns needed to support those spending levels.
- Stress test projections. Use the “Monte-Carlo Analysis” and historical “safe withdrawal” test to mimic the impact of market booms and bust through retirement.
- Develop an appropriate asset allocation. Know the appetite for risk and the portfolio returns needed, and then structure the investments accordingly.
- Use a “Total Return” portfolio approach. This strategy shows the entire picture, where retiree income is derived from a combination of interest income, dividends, and capital gains.
- Rebalance the portfolio. A complete rebalancing accounts for withdrawals and market swings, which can include buying stocks that have fallen in value.
- Rinse and repeat. Every so often, start at the beginning and run through the process again. Strategies like “buckets” or “safe withdrawal rates” are frequently presented as a one-time, set it and forget it retirement plan. Having worked with many retirees over long periods of time, I can say this is not a good idea. In real life, well, life happens. Unexpected life events lead to lumpy and irregular spending over longer time periods, and energy, desires, and priorities change over time. It pays to revisit retirement investment strategies with regular planning.
If you have questions about retirement planning, or would like a second opinion, feel free to get in touch with me at (952) 926-1659, or Scott@CahillFA.com.
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