Northstar’s Charles Farrell: Bucket strategy has some holes in it

When it comes to retirement income management, an approach that is gaining popularity these days is what’s called the “bucket” strategy. Essentially, advisors establish different buckets to use for distribution purposes depending on market conditions.
The bucket strategy is not necessarily an income strategy, it is primarily a liquidation strategy. By a liquidation strategy, I mean a strategy that produces distributions by relying on the sale of assets, as opposed to capturing the income paid on the asset as a source of the distribution.
For the bucket strategy to provide long term retirement security, clients must ultimately experience capital gains on their assets. Otherwise the buckets may run dry long before the end of the client’s anticipated retirement cycle.
I recognize that a great deal of research has been done on bucket strategies and many advisors feel strongly about their effectiveness. And these strategies have contributed greatly to the prospect of a more secure retirement for investors. But given the developments in the financial markets over the last decade, I want to highlight a concern with the strategies that many advisors may not have fully considered.
Let’s take a look at an example of a bucket strategy to illustrate the risk. Assume a client retires with a $1,000,000 portfolio, and sets up a bucket strategy that consists of 3 years of distributions in cash, 7 years of distributions in high quality bonds, and then the rest in long term equity assets (whether they be stocks, commodities, private equity or other types of securities that have an equity risk profile).
Assume the client would like to take distributions of 4% per year, adjusted for a 2% inflation assumption each year. Using a yield of 3.75% on the bonds, to get 10 years’ worth of distributions in the cash and fixed income categories, you would need roughly 40% of the portfolio in those first two buckets. Then, you could allocate the remaining 60% into the equity bucket.
Now assume that equity values decline for 10 years. The bucket strategy would have you liquidate the cash and bonds to get through that 10 year cycle. Then you find yourself at the end of 10 years, with the cash and bonds gone, and the client’s remaining assets in equities. Moreover, the client only has 60% (or less if equity prices have declined) of the portfolio value that he or she started with 10 years earlier.
At the same time the portfolio has been depleted, the distribution needs are rising. After 10 years, the original 4% distribution, if growing at 2% for inflation, would be at about 4.9% of the original account value. If you only have 60% of the account left, that becomes an 8% distribution on the remaining balance. You’ll need substantial and consistent capital gains going forward to support that level of distribution from the remaining assets.
Prior to 2008, I don’t think too many advisors were contemplating periods where equity values might decline for a decade or more. But now we are into the 11th year of lower prices, which means that going forward, retired investors should consider the possibility that the price of the assets they own may not increase for a 10 to 15 year cycle.
Even if your equity holdings are highly diversified on a global scale, asset class correlation statistics are suspect, and changing all the time. What looked like it wasn’t correlated 10 years ago, may end up being highly correlated in the next financial crisis. Thus, you may not get the pricing moves you were counting on. Your only real strategy is time, and a decade may not be enough to provide the client with the time needed for capital gains in the equity bucket.
To enhance the bucket strategy, some advisors may use annuities to create another source of income in retirement. While annuities provide distributions, they also are fundamentally a liquidation strategy, where you are paying back to the investor his principal and using the life expectancy leverage to boost the payout.
Let’s assume you use 25% of the client’s assets to buy a joint and survivor, life-only annuity at age 65. Working with the same $1,000,000 portfolio, the $250,000 annuity would produce about $16,000 of income for the clients for life (this quote was obtained from one of the highest rated insurance companies). That means you have to cover $24,000 of distributions (plus inflation) each year for 10 years in your cash and bond buckets. That would require you to allocate roughly $250,000 to those two buckets, and leave you with around $500,000 to allocate to the equities.
Then assume we have a 10 year cycle of no price appreciation in the equities, and you’ve liquidated your cash and bonds. The remaining amount of your client’s portfolio is 100% in equities, and it’s only worth about half (maybe less if prices have declined) of what the client started with 10 years earlier. Moreover, your only source of income is the $16,000 annuity.
I recognize that a number of bucket strategies call for rolling forward balances from one bucket to the next as the safe money is depleted. But you face the same problem in a period of declining asset prices. If you roll forward money from the risky asset classes when they are down, you are just locking in your losses. If you don’t get your anticipated price appreciation within a fairly short time frame, you are likely to deplete the cash in each bucket.
Admittedly, no foolproof method exists for producing sustainable retirement income. Nevertheless, the bucket strategy may leave clients vulnerable to severe asset depletion during periods of stagnating or declining prices. What are the odds that your clients would experience a 10 to 15 year period of stagnating or declining prices? Who knows, but given recent developments, you may need to plan for it.
Charles J. Farrell, J.D., LL.M., is a principal with Northstar Investment Advisors in Denver, and author of Your Money Ratios: 8 Simple Tools for Financial Security.

Related Topics: Retirement Watch