The inspiration for today's blog post is a recent white paper by Principal Financial Group entitled "Comparing a Bucket Strategy and a Systematic Withdrawal Strategy" that compares and contrasts the two approaches. The FPA's 2011 Financial Adviser Retirement Income Planning Study recently found that approximately 3/4ths of advisors frequently or always use a systematic withdrawal approach, while 38% frequently or always use a "time-based segmentation" (i.e., bucket) approach (as the percentages add up to more than 100%, some planners apparently 'frequently use' both approaches).
For those who aren't familiar, the basic concept of a bucket strategy is relatively straightforward - the retiree divides assets into 3-4 "buckets" that will provide the required cash flows for varying time horizons. For instance, bucket #1 might provide for the first 5 years of retirement and be invested entirely in cash and short-term bonds. Bucket #2 might provide for the following 10 years, and be invested in intermediate and longer-term bonds and perhaps a modest allocation of conservative equities (e.g., a 40/60 allocation). Bucket #3, which won't be required for 15+ years, contains the remainder of the portfolio, which would be invested entirely in equities since the money won't be needed for a long time to come. On the other hand, systematic withdrawal strategies are essentially a safe withdrawal rate approach that simply generates ongoing cash flows by liquidating as needed from a regularly rebalanced diversified portfolio.
Strategies for Portfolio Construction
What's notable about the two approaches, though, is that while their methodology for portfolio construction is framed entirely different, the outcomes are remarkably similar. For instance, let's assume that the client's short-term bucket (years 1-5 in cash and short-term bonds) generates a real return of 0%, the intermediate bucket (years 5-15 in a conservative 40/60 portfolio) generates a real return of 3%, and the long-term bucket (years 15-30 in a full equity portfolio) generates a real return of 7%. If the client wishes to generate $40,000/year of real income, we can discount the future cash flows to derive the required investment portfolio:
The end result? The bucket strategy leads the client to a conservative 41/59 portfolio, not unlike the portfolio any conservative client would select. If the client is less conservative, and adjusts the time horizons according - for instance, by making the second bucket only run for another 5 years (from years 5-10) - the buckets produce a moderate 50/50 portfolio! If the client is slightly more aggressive, and sets the first bucket to only run for 3 years, the portfolio is 60/40.
Which means in reality, the bucket strategy ends out producing substantively similar asset allocations as a systematic withdrawal strategy, ranging from about 40/60 for a 'conservative' client to 60/40 for a more moderate risk client. If you add in some additional dollars to the intermediate and especially long-term buckets to adjust for the danger that below-average returns occur (which can happen, even over long time horizons), you end out with an even more equity-tilted portfolio where most clients are about 50% to 70% in equities... remarkably close to the 'optimal' recommended allocations from the safe withdrawal rate research.
Of course, there are many different ways to assemble a bucket portfolio allocation, involving more buckets, or slightly different time horizons, or varying growth assumptions. Nonetheless, it seems that virtually all of them arrive at substantively similar results, with allocations down near 30/70 or 40/60 for conservative clients, and up to 60/40 or 70/30 for more moderate and risk tolerant clients.
The Same... But Different?
Notably, this isn't meant to suggest that since bucket strategies produce asset allocations that are similar to systematic withdrawal strategies, that they are irrelevant or inferior. In fact, as advocates of the strategy often point out, the bucket approach is arguably superior from the perspective of client psychology; it fits far better into our mental accounting heuristics, and makes the portfolio easier for clients to understand. Furthermore, clients may have an easier time staying the course through market volatility when they can clearly see where their cash flows will come from in the coming years, and that they truly have a decade or more to allow for any declines in the equity bucket to recover. And various buckets can be linked not just to time horizons, but also to separate goals (e.g., the bucket for the vacation house).
The bucket strategy also arguably articulates a clearer systematic strategy to generating cash flows each year than to simply say "we'll sell whatever we need to from a total return portfolio to generate your retirement spending every year."
While the details for many of these prospective psychological benefits are not well tested, much of the existing behavioral finance research supports these benefits conceptually, and many advisors using bucket strategies have anecdotally substantiated them. Which means the reality is perhaps that even if a bucket strategy merely produces the exact same asset allocation and portfolio construction, but does so in a manner that makes it easier for clients to stick with and implement the strategy, it is arguably a superior one.
Unfortunately, though, as the white paper points out, implementing a bucket strategy as the advisor may actually be more difficult, even while it is easier for the client to understand. For instance, standard tools do not exist to calculate the allocations across the buckets (nor is there even a standard framework and set of assumptions to do so); portfolio reporting software generally only reports on investments in the aggregate or by account, but not necessarily by mentally constructed time-horizon bucket. Such software constraints make reporting and oversight of bucket strategies difficult, unless the advisor truly wishes to create one account for each time bucket (which may or may not be administratively feasible for the client, especially if there is a mixture of retirement and taxable accounts). And more monitoring may be required over time, as the advisor must adjust the amount of assets in each bucket from year to year to keep the client on track.
Nonetheless, the bottom line is that even if the asset allocation benefits of the bucket strategy might be a mirage, the psychological benefits may be real enough to merit more attention to the strategy, and more focus on ways that it could be implemented practically across a client base.
So what do you think? Do you use bucket strategies, systematic withdrawal strategies, or something else? Have you ever witnessed any of the 'psychological benefits' of bucket strategies for clients? If the strategies were comparable in portfolio construction but superior in helping clients to stay the course, would that be persuasive enough to make you shift how you build portfolios for clients in retirement?