Nest Egg Withdrawal Mirage

Submitted by Michael Kitces on Tuesday, May 8, 2012 - 3:00pm
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An old method of withdrawing money from retirement accounts, called the bucket strategy, is increasingly popular lately, as a way to work around difficult and volatile markets. But the truth is that there is little actual difference between it and the more widely used approach.

Many think the bucket strategy is superior because it seems so clever: Your assets are divided into different categories, or buckets, and you extract income from them one at a time, at different stages of your retirement. The assets in the earliest withdrawal bucket are the least risky, the ones in the latest are the most risky.

With the more widely used strategy, systematic withdrawals, you extract a set percentage yearly from your asset pool, which is diversified and rebalanced as you age.

The reality is, the differences between the two are largely a mirage, as they result in virtually identical asset allocations. Nonetheless, while the bucket strategy’s implied investment superiority is a mirage, this method still has an important advantage: It is easier to understand and gives you peace of mind.

The inspiration for today's article is a recent white paper by Principal Financial Group, entitled "Comparing a Bucket Strategy and a Systematic Withdrawal Strategy." The Financial Planning Association's 2011 Financial Adviser Retirement Income Planning Study recently found that approximately 75% of advisors frequently or always use a systematic withdrawal approach, while 38% frequently or always use a "time-based segmentation" (i.e., bucket) approach. The percentages add up to more than 100%, as some planners apparently frequently use both approaches. 

Here’s how the bucket strategy typically works. The retiree divides assets into three to four buckets to provide cash flows for varying intervals. For instance, Bucket Number One is for the first five years of retirement. It is invested entirely in cash and short-term bonds.

Bucket Number Two covers the following 10 years. It’s composed of intermediate and longer-term bonds and perhaps a modest amount of conservative equities, with a 40-60 stock-bond allocation.

Bucket Number Three, which is used after the 15th year of retirement, contains the remainder of the portfolio, invested entirely in equities since the money won't be needed for a long time.

By contrast, a systematic withdrawal strategy would simply hold a set diversified portfolio in a single “bucket.”

Strategies for Portfolio Construction 

While the two approaches’ methodology for portfolio construction is different, the outcomes are remarkably similar. Assume that your short-term bucket (years one through five in cash and short-term bonds) generates a real – that is, inflation-adjusted – return of 0%. The intermediate bucket (years six through 14 in a conservative 40-60 portfolio) returns 3%, and the long-term bucket (years 16 to 30, all equities) 7%. If you want $40,000 per year of real income, we can discount the future cash flows to derive the required investment portfolio:

 

 Stocks

Bonds

Total 

Short-Term 

$0

$200,000 

$200,000 

Intermediate-Term 

$121,264 

$181,895 

$303,159 

Long-Term 

$141,288

$0 

$141,288 

Total 

$262,552 

$381,895 

$644,447 

Allocation

41% 

59% 

 

The result? The bucket strategy leads to a conservative 41-59 portfolio, much like the 40-60 portfolio any conservative client would select. If you are less conservative, and adjust the time horizons accordingly – for instance, by making the second bucket only run for another five years (from years six through 10) – the buckets produce a moderate 50-50 portfolio. If you are more aggressive, and set the first bucket to only run for three years, the portfolio is 60-40 – the same moderate growth portfolio an investor might receive anyway under a systematic withdrawal approach.

Thus, the bucket strategy ends up producing substantively similar asset allocations as a systematic withdrawal strategy, ranging from about 40-60 for a conservative investor to 60-40 for a more moderate risk one. If you add in additional dollars to the intermediate and long-term buckets to adjust for the danger of below-average returns (which can happen, even over long periods), you get an even more equity-tilted portfolio, where most clients are about 50% to 70% in equities. That’s 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, virtually all of them arrive at substantively similar results, with allocations down near 30-70 or 40-60 for conservative investors, and up to 60-40 or 70-30 for more moderate and risk-tolerant people.

The Same... But Different? 

The bucket approach is arguably superior from the perspective of investor psychology. It fits far better into our mental accounting heuristics, where people separate their money into categories and treat it differently:  money inherited from grandma for a house down payment is treated different than a large amount of cash in an emergency fund, even though it’s the same liquid investment and could easily be pooled together. But since we like to account for groupings of money differently in our heads, a bucket strategy makes the portfolio easier to understand.

Furthermore, a bucket strategy makes it easier to stay the course through market volatility. You can clearly see where cash flows will come from in the future, and that you have a decade or more to recover from any declines in the equity bucket. And various buckets can be linked not just to time horizons, but also to separate goals (e.g., the bucket for the vacation house).

Michael Kitces, MSFS, MTAX, CFP, CLU, ChFC, is a partner and the director of research for Pinnacle Advisory Group, a private wealth management firm located in Columbia, Md., that oversees approximately $1 billion of client assets, and Pinnacle Advisor Solutions, a firm that provides outsourced investment management services for financial advisors. He is the publisher of the e-newsletter The Kitces eport and the blog Nerd’s Eye View through his website www.Kitces.com. Kitces is also one of the 2010 recipients of the Financial Planning Association’s “Heart of Financial Planning” awards for his dedication to advancing the financial planning profession. Follow Kitces on Twitter at @MichaelKitces.

 
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