The Pros and Cons of Bucket Strategies

Continuing recent posts updating my past descriptions of retirement strategies, let’s look again at time-segmentation (TS) or “bucket” strategies.

The basic implementation of time segmentation strategies sets aside enough cash and short-term bonds to cover the next few years of retirement expenses, let’s say five, then covers the following few (let’s say years six through ten) years’ expenses with intermediate bonds, and finally allocates any remaining assets to stocks.

Note that this is a markedly different way of allocating assets than is typically used by other strategies that base equity allocation on the largest loss a retiree can stomach in a market downturn and the optimal asset allocation to avoid prematurely depleting a savings portfolio.

Many retirees will find that setting aside five or six years of expenses in a cash fund will be a significant portion of their investable assets so this might be a dramatically different allocation.

Here’s an example. A retiree wants to spend $40,000 annually from a $1M portfolio. She invests a little less than $200,000 in cash and short-term bonds (the discount rate is low, especially in today’s capital markets, so we can roughly just multiply annual spending by 5) to cover expenses for the next five years. She invests a little less than $200,000 (less because they yield a little more) in intermediate bonds and roughly $600,000 in stocks. It is her estimated future spending that determines her asset allocation of 20% cash, 20% bonds and 60% stocks.

TS strategies don’t typically recommend an annual safe spending amount like the $40,000 in this example but this can be estimated by any of the (preferably variable) spending strategies.

This part of the TS strategy is based on matching asset duration[1] to the duration of expenses and is financially sound.

Asset duration, in simplest terms, refers to the recovery period typically needed after a market downturn or interest rate increase. The duration of an expense is essentially the number of years until it is due but expected inflation must be considered, too.

Matching a near-term liability with a long-duration asset like stocks would provide a greater expected return but less confidence that the money would actually be available when needed if stock prices declined. Matching a long-term expense with an intermediate bond would have greater certainty but a lower expected return. “Liability matching” provides the greatest asset return for which the expense can be reliably met and is a key component of TS strategies.

Short-term bonds may have a duration in the neighborhood of three years, intermediate bonds 5-10 years, and stock market duration is measured in decades. This simply means that we can be pretty sure of the value of a 3-year bond in three years but not less, the value of cash next year, and that we probably need to invest in stocks for 7-10 years to be pretty sure our investment won’t be looking at a loss.

Planners often recommend that the bonds are set up as a ladder held to maturity to mitigate interest rate risk but many planners simply use bond funds of short and intermediate durations assuming that the results will be “close enough” to those of bond ladders.

The expressed goals of TS strategies are to match expense durations to asset durations, to help retirees better understand the purpose of their different assets, and to weather bear markets without the need to sell stocks at depressed prices and thereby avoid “panic selling” in a market downturn.

Liability-matching is a sound financial policy, while the latter two are primarily psychological benefits. In fact, from a financial perspective, to quote Wade Pfau:

… it must be emphasized that on a theoretical level, income bucketing cannot be a superior investing approach relative to total returns investing.[2]

The reason is that bucketing typically requires a much larger cash and short-term bond allocation than other (total return) strategies. The difference between the returns available from these two assets and what their value might have earned in the stock market is referred to as “cash drag.” You simply earn less money if a larger portion of your portfolio is held in cash instead of invested in stocks.

In a paper entitled, “Sustainable Withdrawal Rates: The Historical Evidence on Buffer Zone Strategies[3], authors Walter Woerheide and David Nanigan showed that the drag on portfolio returns from holding large amounts of cash can be significant.

In other words, the comfort of a large cash bucket can come with a heavy cost. According to the authors, the performance drag imposed by a large cash bucket actually leaves the typical portfolio less sustainable. That suggests that TS strategies increase the security of income for the next ten years but do so at the cost of less security of income in the years beyond.

Said differently, the goal of TS strategies is to reduce sequence risk, i.e., to reduce the probability of outliving one’s savings, by encouraging the investor to avoid selling stocks at low prices. Woerheide and Nanigan, however, show that this strategy’s cash drag is typically greater than the benefit of avoiding selling low and often achieves the opposite, a less sustainable portfolio.

Are bucket strategies easier for retirees to understand or is their explanation simply easier to get away with?

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The goal of building a cash bucket to weather bear markets conflicts with the goal of maximizing portfolio returns (and thereby increasing portfolio sustainability) and can backfire. The longer the cash bucket the greater the cash drag. The shorter the cash bucket the less likely it is to outlast a bear market.

It has also been argued that TS strategies reduce sequence of returns risk and they probably do when they work, meaning when they outlast the bear. But, Moshe Milevsky showed in “Can Buckets Bail Out a Poor Sequence of Investment Returns?” that this strategy cannot always avoid sequence risk. When a retiree spends all his cash in a market downturn he can be left with an extremely risky all-equity portfolio, possibly before the bear market ends, with the postponed selling having had the unhappy effect of waiting to sell stocks until near the market’s bottom.

Technically, bucket strategies are not “floor and upside” strategies but, as I have noted in previous posts, most Americans are eligible for Social Security retirement benefits. Consequently, most Americans have a floor, no matter which strategy they prefer, though it may not be what a retiree would consider an adequate floor — living off Social Security benefits alone isn’t pretty.

While floor-and-upside strategies are meant to provide confidence that the retiree will never fall below a certain level of income for a lifetime, bucket strategies attempt to inspire that confidence (not always justified, as Milevsky explained) for only the length of the bond ladder.

I often think of the floor issue by imagining that my upside portfolio has been completely depleted. This is an unlikely scenario to be sure unless one is spending from that portfolio, but it forces me to imagine my circumstances in a potential failure scenario. Using a bucket strategy, I would have no stocks from which to replenish the longest rungs of the bond ladder in that event, so my income beyond this “rolling ladder” is clearly dependent upon equity performance and is not secure.

The stock allocation will decline with age as the short- and intermediate-term buckets slowly come to dominate the portfolio. At some age, the portfolio will contain mostly bonds and cash.

TS strategies recommend spending first from cash, then from bonds, then from equities, but as the Michael Kitces explains[4], that is pretty much what happens when we rebalance a SWR portfolio. Rebalancing results in selling assets that have recently experienced the highest growth. If stock prices have fallen, rebalancing ensures that it is other asset classes that will be sold. With rebalancing, stocks are sold after their prices go up.

Lastly, how many retirees — or planners, for that matter — understand these risks?

It’s simple enough to explain to a retiree where the funds are coming from to pay bills for the next several years. But, unless she also understands that buckets can fail, that increasing the cash bucket to avoid failure dilutes her expected portfolio returns, and that income for future years funded by the stock market is still at risk, then this benefit of bucket strategies is not a true understanding but simply a psychological salve.

If that’s the case, are bucket strategies easier for retirees to understand or is their explanation simply easier to get away with? The arguments for bucket strategies are not that the strategy itself is easier to understand but simply that it is easier to understand the purpose of their asset allocations.

Planners report that bucket strategies improve the bear-market behavior of their clients and their planners find that quite valuable. There’s nothing wrong with that if the retiree understands the cost of this behavior management — the long-term sub-performance of an overly-conservative TS portfolio is likely outweighed by the losses they avoid by not selling low.

It’s hard to evaluate that comparison because it is largely dependent upon the retiree’s self-control but it seems a steep price to pay for this guardrail, especially compounded over a long retirement.

A strong urge to sell in bear markets could just be a sign of an overly aggressive asset allocation. Finding a more tolerable asset allocation between that and a 20% cash allocation might be a better answer.

No retirement funding strategy is perfect and I think a sub-optimal strategy is better than no strategy. Or, as my friend, Peter is fond of saying, bad breath is better than no breath at all.

Ultimately, I firmly believe that the best retirement plan is the one that lets you sleep at night.


[1] Efficient Frontier, William Bernstein.

[2] The Yin and Yang of Retirement Income Philosophies, Wade D. Pfau, Jeremy Cooper.

[3] Journal Sustainable Withdrawal Rates: The Historical Evidence on Buffer Zone Strategies, Walter Woerheide and David Nanigan.

[4] Is A Retirement Cash Reserve Bucket Unnecessary?, Michael Kitces.


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