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Retiring Soon And Scared Of The Market? The Two-Bucket Strategy Can Help


Every day, about 10,000 baby boomers turn 65⁠—the traditional retirement age. One thing retirees, near-retirees and professionals managing boomers’ investments understandably worry about a lot these days: What happens if the market crashes just when a retiree needs to pull funds from his portfolio to live on?

A long-used rule of thumb (known as the Bengen rule) holds that if you retire at 65 you can withdraw 4% of the starting value of your investment portfolio (adjusted for inflation) for 30 years without running out of money. That’s based on looking at the worst historical market performance over 30 years. But needing to sell off stocks during a bear market early in your retirement can undercut that calculation. (Financial geeks describes this as sequence-of-returns risk.)

“The sequence-of-returns risk is the risk that your early retirement withdrawals occur in a down market. A down market in those years raises your risk of outliving your funds because you are withdrawing from an account that has lost a significant amount of money,” says Jillian Nel, principal and director of financial planning for Legacy Asset Management in Houston

That’s why financial advisors are increasingly touting a strategy for handling that risk that is popularly known as the retirement-income bucket strategy.

Bucket strategies come in different varieties and with different purposes. The simplest approach when it comes to retirement income is the two-bucket strategy. Put simply, someone approaching or in retirement uses two types of portfolios or “buckets”: a cash flow reserve bucket for spending in the next two to five years and a long-term investment bucket that will help to refill the cash flow bucket over time.

We’ll get into how the two-bucket strategy works later. But, first some background.

Quick History of The Two-Bucket Strategy

Prior to the Great Recession, brokers and financial advisors prized market-beating performance and short-term gains, says Harold Evensky, chairman of Evensky & Katz Foldes Financial Wealth Management in Lubbock, Tex. The recession triggered a shift to more holistic approaches as advisors discovered their clients’ true risk tolerance perhaps wasn’t as great as they’d previously assumed.

Job losses and the housing crash combined to heighten clients’ concerns about their diving stock portfolio values. All this pushed more advisors to move toward portfolio strategies that were better aligned with clients’ goals and the time frame of those goals.

Goals-based investing⁠—and the related use of different buckets to fund different goals⁠—isn’t new, but it has been spreading and has become more accessible. (For example, what’s known by the folksy “two-bucket strategy” name was originally called the cash-flow-reserve distribution strategy.)

Evensky and his firm developed a bucket retirement strategy in 1985 that helped clients weather the 1987, 2000 and 2008 market crises. After each of those traumas, more advisors started seeing its wisdom.

The Two Bucket Strategy

The Cash Bucket

The goal of this strategy is to protect retirees against market risk, cut down taxes and transaction costs and keep financial planning simple.

“If you take money out [of your investment portfolio] at the wrong time, meaning the market is down and your portfolio is down in value, that can do serious long-term harm,” explains Evensky. “So, the idea of the bucket strategy is to protect against the risk of taking money out at the wrong time.”

To avoid that risk, Evensky tells his clients to keep five-years worth of money needed for living expenses out of the stock market. (Keep in mind, that this is the cash you’ll need after accounting for any income you have coming in from Social Security, pensions and annuities.)

Money needed within the next year or so can be held in money market accounts, savings accounts or short term bond funds. “There are many good short-term bond funds out there where there’s very little risk of interest rate risks (that is, the value of the fund going down because interest rates have gone up),” says Evensky. (Your tax bracket could influence whether you use a taxable or tax exempt short term bond fund.)

To finance goals that are three to five years out, he suggests, consider a certificate of deposit (CD) that will mature when you’ll need the money.

Why five years? That’s “roughly an economic cycle,’’ Evensky answers. The measure from peak to peak or trough to trough, lasts around an average of five and a half years. That five years of cash should get a retiree through a bear market, correction, or recession, without risking his retirement or his peace of mind.

Some financial advisors now suggest their clients don’t retire until they’ve put five years of income in their cash (and cash-equivalent) bucket. If you expect to spend $5,000 a month, and have $2,500 of Social Security and pensions coming in, than you’d need $150,000 in your cash bucket⁠—that’s $2,500 a month times 60 months (five years).

Make sure you put enough in that cash bucket to cover special expenses you think are important. Perhaps in the next five years you’re planning to help pay for a child or grandchild’s college education or to take that bucket list foreign trip. (Sure, in theory, you can put off a trip. But for how long? The reality is that leisure spending, which goes up after retirement, tends to start declining after 75, as aging retirees stick closer to home.)

Between January 1, 2008 and January 20, 2009, individuals with 401(k) account balances of $200,000 or more and those who had been in their plans for more than 20 years lost an average of more than 25% in the value of their accounts, according to the Employee Benefit Research Institute.

Among those aged 56 to 65 (meaning, they were nearing retirement), losses varied widely, as did equity exposure. But for some, their exposure to stocks was surprisingly high. For example, more than two in five of these near-retirement workers had more than 70% of their money in stocks before the crash, and nearly one in five had more than 90% of their balances in equities, EBRI found in its February 2009 analysis. The think tank noted in its analysis that the recovery time would depend on future returns, but estimated it would take the average 401(k) from two to five years to recover.

New retirees who had ample cash reserves wouldn’t have to sell during that recovery period.

A related reason to use a two bucket strategy: avoiding panic. A small percentage of those nearing retirement sold all the stocks in their portfolios after the market crashed and they never got back into stocks, a 2011 study by benefits consultant Aon Hewitt and Financial Engines found. In other words, they forfeited the opportunity for their portfolios to recover. The cash reserve bucket can help to immunize aging investors against that sort of value-destroying sell-at-the-bottom panic.

The Investment Bucket

As an example, suppose you have $1 million saved and you want $100,000 in your cash bucket. That would leave $900,000 to be fully invested. Your investment portfolio could have two investments: a stock fund and a bond fund or whatever you think suits your long-term goals.

Evensky suggests that you review your investment portfolio quarterly and rebalance only when the current allocation is off kilter from your allocation policy. You can then use the reallocation process to refill your cash bucket. For example, say the stock market has been on a tear and you’re now more heavily allocated to stocks than you intended. That’s a good time to sell some stocks and move the proceeds to your cash bucket. Similarly, Evensky says, when the stock market tanks and your portfolio is heavy in bonds (which tend to do well during such times) then you could sell off some bonds.

“There is a potential opportunity cost (i.e., having some funds not invested in the market) of putting funds in a (cash) reserve account but our research shows that cost is more than offset by avoiding the risk of having to sell assets in a down market,” says Evensky. “Also, the behavioral advantages, although not measurable, are potentially significant.” He notes that an investor can offset some or all of the opportunity cost of keeping a large cash reserve by increasing the equity allocation of the investment portfolio.

Other Retirement Buckets

Financial planner Jillian Nel uses either a two-bucket or three-bucket approach. She uses the two-bucket strategy when her clients are far (more than 10 years) away from retirement. The three-bucket strategy is when her client is around the corner from retirement.

In the three bucket approach, the first bucket is a cash bucket. The second bucket is designed to help investors refill their cash account when the markets are down so it might include bond ladders and alternative investments that don’t move in sync with the markets. The third bucket is an aggressive portfolio for when the market is up, so Nel constructs those as 70% stocks and 30% bonds or 80% stocks and 20% bonds, depending on a specific client’s risk tolerance level.

A 70% or 80% stock allocation is typically suggested for people in their 40’s and younger, so that tells you how aggressive the third bucket can be.

To help her determine how to fund a client’s cash flow account, Nel has clients who are nearing retirement plan out a detailed budget, including both the necessities and frills. She looks at the possibility of the markets dropping two years before retirement or right after retirement and makes the bucket big enough to cover the recovery time.

There’s quite a bit of debate about how many investment buckets one should have and what to put in each. There is a goals-based bucket strategy where people design investment buckets around specific goals they have. They’ll have a college bucket for a child or grandchild, a family-trip bucket and a second-home bucket, as an example.

Then there is the time horizon bucket strategy. You set up a short-term bucket for things you’ll need in one to five years, a bucket for six to 10 years and another bucket for investing long-term—say 10 to 20 years. Both Evensky and Nel believe, however, that having too many buckets can make rebalancing too complicated and could also create excess transaction and tax costs.

Bucket Strategy Drawbacks

If you’re set on a bucket strategy, the question is which one. Let’s look at a few of the downsides of various approaches.

“The problem with [goals-based buckets] is people’s goals are not chronological,” says Evensky. “So if you have a goal that you’ve funded and you don’t need all the money [and] it comes after one of the earlier goals, you can’t go back and use that money for one of the earlier goals. It just doesn’t fit the way people really live.”

With time horizon buckets, people invest more aggressively in their longer-term buckets. But Evensky thinks people may grow uncomfortable with such a high equity allocation as they get older.

The two-bucket approach has its critics too. “[The two-bucket strategy] is on the right track, but it doesn’t take the train all the way to the station,” says Don Schreiber Jr., founder, CEO and co-portfolio manager at WBI Investments. Schreiber argues it places too much responsibility on the investment bucket. He’s also not convinced that this strategy will keep retired investors from panicking and liquidating their equity investments in a bear market.

Schreiber gave the example of a retired investor with $1 million saved and an income need of $4,000 a month, or $48,000 for the year—equal to 4.8% of her retirement kitty. The retiree places three years of spending needs ($144,000) into her cash flow bucket. That means a bit shy of 15% of her savings are in a cash reserve, while the remaining 85% gets fully invested. With three years of cash set aside, the advisor will likely invest the 85% more aggressively and expose the portfolio’s capital to larger declines. What happens if a bear market reduces her invested portfolio by 40% or about $342,000? “When people see their capital disappear, they won’t ignore that,” answers Schreiber.

That could be true for the faint of heart, but it may not be the case for all retired investors. After all, Evensky said he didn’t receive any phone calls from distressed investors on Black Monday—that day in October 1987 when the Dow average fell nearly 23%. When he and his team made phone calls to check, they quickly discovered that their clients were emotionally fine with the extreme market volatility.

Courtesy : Forbes

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