Comparing a Bucket Strategy and a Systematic Withdrawal Strategy

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1 Comparing a Bucket Strategy and a Systematic Withdrawal Strategy By Noelle E. Fox Article Highlights Advisers often present retirees with either a systematic withdrawal strategy or a bucket strategy. A systematic withdrawal strategy may require less time to create and maintain. A bucket strategy may help investors feel more confi dent that their savings will last throughout their retirement years. One of the most important services financial professionals offer their investors may be a well-structured and sustainable retirement income strategy. Considering the many methods for structuring such a strategy, this process may be overwhelming to retirees and financial professionals alike. The risks in retirement are different from the risks an investor may have faced while accumulating retirement assets, and often a retiree needs help to thoroughly understand and evaluate these differences. A financial professional s guidance can be of great help throughout this process. One approach to developing a retirement income plan is the bucket strategy. A bucket strategy segments retirement assets by certain categories. Categories may be based on the risk level of the assets, the needs or expenses these assets are expected to cover or the period of time in retirement when the assets are expected to generate income. The most widely used bucket strategy is the time-segmentation approach, which is used by almost one-third (28%) of financial professionals, according to the Financial Planning Association. This approach assigns each bucket to a defined time period in retirement, based upon the retiree s risk tolerance and time horizon. It anticipates that the allocation will shift over time to traditionally more conservative asset classes as the retirement savings are drawn down. This article analyzes the potential advantages and shortfalls of the time-segmented bucket strategy, which we refer to here as simply the bucket strategy, by comparing it to the most common strategy in use systematic withdrawals. The two strategies are compared based on the psychological and economic benefits they can offer a retiree. More on the Bucket Strategy While the bucket strategy will have buckets of funds designated for use in specific retirement time periods, there are other attributes that will create differences among particular strategies. Depending on the preference of the investor, the funds may be redistributed among buckets more or less frequently. Generally, most bucket strategies also have a target for how much cash and short-term investments to keep on hand for current spending needs the basis for this target may differ by method. To better understand the bucket strategy, we demonstrate it with an example that utilizes three buckets, as shown in Figure 1. When initially established, the first bucket contains cash and cash equivalents and is intended to be utilized and contain sufficient funds to meet spending over the first five years of retirement. The second bucket is intended to meet spending needs in years six to 15 of retirement. It contains mostly fixed-income securities, which are likely to experience greater volatility than cash, but, because they are in the second bucket, the retiree has a longer time period to ride out market swings. The third bucket contains mostly equities, a traditionally more risky and volatile asset class. It is intended to meet expenses in the years beyond the 15th year of retirement, again providing opportunity to ride out swings with the intention of reaping the potential rewards. 7

2 Figure 1. The Bucket Strategy These buckets will need to be redistributed over time. At a regular frequency, the first bucket will need to draw from the second to continue to meet its intended use of covering expenses over the next five-year period. For the second bucket to continue to meet its intended use, it will need to draw from the third. Should market returns create sufficient balances to meet each bucket s objective, a redistribution among buckets would not occur. The balances of each bucket would be analyzed at a regular frequency, and, if a certain target balance isn t met, then a redistribution would occur. Psychological Benefits According to an AARP bulletin, the majority of people fear running out of money in retirement more than they fear death. It s no wonder many people look to financial professionals for help as they enter retirement. While working with a financial professional on any type of retirement income strategy can help a retiree feel more confident in his or her plan, research conducted by HSBC has shown that the bucket strategy may provide some additional psychological benefits. A bucket strategy can address a human preference for smaller, simplified issues, according to finance professor Meir Statman. For retirees feeling overwhelmed by the many decisions they face as they enter retirement, a bucket strategy may help them divide what they see as one large, stress-inducing problem into smaller, more manageable pieces. A bucket strategy that links portions of money directly to goals may also promote self-control, according to the Retirement Income Journal. This can serve as a form of mental accounting, much like a budgeting method using envelopes. By setting aside a budgeted amount of money each month for specific purposes, like groceries, people may find it easier to stay disciplined and spend within a budget. With a bucket strategy, a retiree would use a smaller portion of his or her savings that is designated for income in the short term rather than the entire retirement balance. The designated bucket may help the retiree feel more in control, since creating a sustainable income stream from a large pool of assets can often be a daunting task. While creating a strategy for retirement can help inspire confidence and possibly reduce stress, a systematic withdrawal strategy may have fewer psychological benefits than a bucket strategy. Even when structured with a 4% to 5% withdrawal rate and asset allocation, systematic withdrawals lack the structure of a bucket strategy. As a result, a systematic withdrawal strategy tends to provide fewer psychological benefits. Because money isn t segmented to directly linked goals, the plan may still feel overwhelming to a retiree. Viewing the total account balance rather than the smaller portion intended for short-term use may lead to more dramatic overreaction when account balance swings occur. An Economic Comparison It s also important to compare economic benefits associated with each strategy. For example, for a less timeintensive retirement income strategy, a systematic withdrawal strategy from a target date mutual fund may be set up. With target date funds, the portfolio managers invest in generally more aggressive underlying assets, such as equities, when the target date, which is intended to be an individual s retirement date, is far away. The portfolios gradually become more conservative by shifting their allocations from equity to fixed-income assets as the target date approaches. It is expected that the target date is the date at which the individual will begin withdrawing money. Once in retirement, target date funds generally assume the value of the account will be withdrawn gradually over time. Some funds continue to increase their allocation to traditionally more conservative asset classes beyond the target date, while others do not. Generally, neither the principal nor the underlying assets of target date funds are guaranteed at any time, including the target dates. Investment risk remains at all times. In this example, we consider a target date fund set up for investment through retirement, not just to the target date. The mix of investments gradually shifts to traditionally more conservative asset classes as the retiree ages. At a very basic level, a bucket strategy would replicate this outcome. Based on the established timeline, assets would shift from more aggressive buckets designed for long-term use to traditionally more conservative buckets designed for short-term spending needs. The short-term bucket is generally designed to provide a steady, inflationadjusted income similar to a systematic withdrawal strategy from the target date fund. Structured correctly, these two strategies a bucket strategy and systematic withdrawals from a target date fund could have a similar result, as shown in Figure 2. In the real world, a bucket strategy will probably not perfectly mimic a 8 AAII Journal

3 Figure 2. Sustainability of a 5% Inflation-Adjusted Withdrawal Rate From a Target Date Fund* systematic withdrawal strategy from a target date fund. In part, this is because a bucket strategy reallocates differently than a target date fund. Bucket strategies redistribute funds only from the bucket containing more aggressive assets to less risky buckets, not the reverse. On the other hand, target date funds rebalance to a predetermined asset allocation. If high-quality, shortterm bonds in the first bucket experienced a great year, the bucket strategy would likely not redistribute funds. The key is for the bucket to achieve its goal of maintaining cash on hand to cover the next five years of retirement. However, in the same scenario, a target date fund would rebalance some of the gains to other asset classes with potentially greater risk and return potential. Said another way, a bucket strategy sets asset allocation based on market movements, while a target date fund sets asset allocation based on a glide path intended for a certain investor age. For example, assume traditionally more aggressive investments performed very well in a given year, leading to large end-of-year account balances in the riskier portion of the allocation. If using the bucket strategy, funds would not redistribute. Redistribution would occur only if the shorter-term buckets were not meeting their intended objectives. On the other hand, a target date fund would rebalance back to the targeted asset allocation, likely reducing the large balance in the riskier investments. This difference will cause the asset allocations of the bucket strategy and target date fund to increasingly differ from one another over time. Customization may lead to other differences between the two strategies. In some situations, a retiree may prefer to redistribute among the buckets more or less frequently than a target date fund rebalances. A target date fund will likely have allocation targets that change annually. Another preference may be the specific target to set for cash and short-term investments. One retiree may consider five years of future income to be the right amount of funds to store in short-term investments for immediate use, while another might prefer a three-year horizon. This decision will have a large impact on how the asset allocation changes through retirement. To see how these key differences may impact income sustainability through retirement, variations of bucket strategies have been modeled against a hypothetical target date fund with systematic withdrawals. Both methods aim to provide a 5% initial withdrawal, increased by 3% each year to help offset inflation. We project the probability of still having remaining retirement funds as assets are drawn down from 15 to 35 years into retirement. The next two figures isolate the potential impact of two key bucket strategy levers: the frequency of redistribution and the number of years covered by the cash target. Figure 3 shows the differences created by varying the frequency of redistribution among the buckets. In each of the bucket strategies, the cash target has been held constant, aiming to always keep five years of future income in cash and short-term investments. In Figure 3, you can see the potential impact of two key differences between a bucket strategy and a target date fund. First, the bucket strategy redistributes among buckets, while the target date fund rebalances. In a bucket strategy, funds never move from a traditionally more conservative bucket to a more risky bucket. Accordingly, this strategy may tend to become conservative early, thus making it difficult to sustain income throughout retirement. Second, while the target date fund rebalances regularly, the bucket strategy may redistribute less frequently. Figure 3 shows that less frequent redistribution may help income sustainability. Less frequent redistribution may allow the bucket strategy to stay invested in tradi- 9

4 Figure 3. Sustainability of Income From a Target Date Fund* Vs. Bucket Strategies With Varying Redistribution Frequencies tionally more risky investments instead of redistributing to more conservative investments. Redistributing, especially at a higher frequency, may cause the bucket strategy to hold more cash and experience lower returns over the long term as compared to a target date fund. Next, Figure 4 looks at another key lever: the number of years covered by the cash target. The frequency of redistribution is held constant for this diagram, redistributing every three years. This way, the potential impact from a higher or lower cash target can be seen in isolation. In Figure 4, the bucket strategy shows better outcomes when a lower cash target is used. The lower cash target means fewer assets shift to more conservative investments, encouraging the portfolio to earn a higher average return over the long term and potentially creating better odds of meeting income needs throughout retirement. Figure 4 shows that a bucket strategy may perform better with a lower cash target, but it also shows that a systematic withdrawal from a target date fund could perform even better. Because a bucket strategy redistributes funds among buckets rather than rebalancing, it shifts the overall portfolio to a traditionally less risky allocation compared to that in a target date fund. Redistributing less frequently and setting a lower cash target may keep this shift from occurring too quickly, causing the bucket strategy to potentially perform more like the systematic withdrawal strategy. Of course, this isn t an exhaustive analysis of bucket strategies. Should a retiree want to use either a bucket strategy or a target date portfolio with systematic withdrawals, there are myriad ways the strategy could be customized to meet his or her needs. A key takeaway, however, is that while you may expect the economic benefits of the more timeintensive bucket strategy to trump those of a systematic withdrawal approach, they may not. A systematic withdrawal strategy can be just as sustainable for the retiree and less time intensive. Trade-Offs Both the bucket strategy and systematic withdrawal methods have pros and cons. While a bucket strategy may be more time intensive, it may also structure a regular retirement income plan check-up through the redistribution. The redistribution process sets a designated frequency to evaluate the portfolio. A simpler plan may go unchecked for long periods of time. A bucket strategy may also give the retiree more psychological benefits, if he or she feels that the buckets of money are easier to maintain when directly linked to goals. While a systematic withdrawal approach may make just as much sense financially, a retiree may simply feel more secure with a bucket strategy. The bucket strategy may also help extremely risk-averse investors, who may not elect to invest in any stocks, to take a more long-term approach to investing. As Figures 2 through 4 show, it may be necessary to have some retirement funds allocated to traditionally riskier investments to help support income through retirement. By segmenting the buckets by time of intended use, more risk-averse investors may feel more comfortable with a balanced portfolio. Problems Left to Solve Navigating through the new experiences and risks in retirement will often involve more than just developing a retirement income strategy. The strategies highlighted in this article naturally involve various forms of risk, which a retiree should discuss with their financial professional. Five key retirement risks include: longevity, market performance, with- 10 AAII Journal

5 Figure 4. Sustainability of Income From a Target Date Fund* Vs. Bucket Strategies With Varying Cash Targets drawal rate, inflation and health care. Both a bucket strategy and a target date fund, through thoughtful planning, may help to mitigate market performance, withdrawal rate and inflation risk; however, these risks are not completely negated. Diversification and regular rebalancing may decrease the impact of market volatility, but the risk of losing money will still exist. A financial professional might recommend a sustainable withdrawal rate, generally 4% to 5% with adjustments each year for inflation, but investors may not heed this guidance. While a good retirement income plan should recognize inflation risk, the strategies highlighted in this article cannot completely protect against drastic increases in the cost of living over a retirement that may last 30 years or more. Neither strategy will protect against the risks of longevity or health care. However, both strategies should include a reasonable, inflation-adjusted withdrawal rate, which seeks to protect against running out of funds at an old age. Either strategy could do more to account for longevity risk by incorporating a guaranteed product, like an annuity or longevity insurance. The risk of health care expenditures in retirement should be considered. In short, it s important for retirees to have direct discussions with their financial professionals about the issues faced when entering retirement. While many risks can be mitigated, the retiree must understand that no plan is perfect and regular maintenance is crucial. Conclusions A bucket strategy is one logical way to structure a retirement income plan. By creating budgets with categories of funds, investors may gain psychological benefits from the mental accounting behind the bucket strategy. While an investor may feel more secure with money segmented and designated for future use, the strategy may not provide financial benefits beyond what may be accomplished with a less complicated strategy. Structuring systematic withdrawals from a target date fund can be a straightforward strategy for creating retirement income for some investors. When considering a bucket strategy or systematic withdrawals for retirement income, certain trade-offs should be considered. A bucket strategy can be time intensive to implement and maintain; however, it encourages regular maintenance of the retirement income strategy, which is critical. For an especially risk-averse retiree, it may allow acceptance of a more risky portfolio. No product or strategy is the single best choice for all retirees. Financial professionals play a critical role during the transition into retirement, discussing the new risks a retiree faces and helping structure a strategy to help the retiree receive income he or she needs through retirement. The retirement income strategies financial professionals structure for investors whether they use a bucket strategy, a systematic withdrawal strategy or some other method must be based on individual investor needs and risk tolerances. The end result is that, with the help of a financial professional, retirees may spend less time worrying about income sustainability and more time enjoying their well-deserved retirement years. Noelle E. Fox is a practice leader in the Retiree Services Division of Principal Financial Group. Find out more at authors/noelle-fox. 11