The single biggest concern for retirees and the financially independent is how to ensure that they do not outlive their assets. Endless studies have been made on safe withdrawal rates, including those originating the “4% rule.” Fears over long-term income shortfalls are why insurance salesman pushing complex, expensive “guaranteed lifetime income” variable annuities have so much success preying on unsuspecting retirees.
One very popular approach to retirement income planning is the so-called “bucketing” strategy. In this scenario, a financial professional will recommend that a portfolio be divided into “short term,” “intermediate term,” and “long term” buckets. The “short term” bucket is usually cash and equivalents, worth around 2-3 years of living expenses, approximately 10% of the portfolio value. The “intermediate term” bucket is either bonds or a conservative mix of stocks and bonds, and the “long term” bucket is more stock-heavy. Investors can rely on the short-term bucket in periods of market turbulence, and refill the short term bucket when market gains are healthy.
This approach gives investors the warm fuzzies. It plays to our behavioral biases and it is a nice mental accounting trick. I have long held that in practice it is no different (and no better) than a diversified portfolio of stocks and bonds (including short-term bonds). I am feeling very validated today by new research from super-planner Michael Kitces. In a new piece, Kitces lays out a solid comparison of two strategies: bucketing and portfolio rebalancing. In short Kitces demonstrates that bucketing is no different than a diversify-and-rebalance approach, and that bucketing without regular rebalancing is actually worse than a simple rebalancing system alone. Do yourself a favor and read the piece in its entirety: Managing Sequence Of Return Risk With Bucket Strategies Vs A Total Return Rebalancing Approach. (Fair warning, the piece is long and occasionally technical as Kitces usually is!)
The heart of this planning issue is that portfolio rebalancing is an incredibly powerful force both for savers and for those living on portfolio distributions. I know that I am beating a very well-worn drum but this type of research is exactly why I harp on the fact that investors need to have an investment policy in place with a clearly defined rebalancing procedure. I am regularly reminding clients that rebalancing does three things very well:
1) Rebalancing according to a pre-defined policy removes any guesswork from the decision-making process, minimizing the impact of our (deeply flawed) behavioral biases;
2) Rebalancing keeps our portfolios structured at a level of stock exposure that we originally agreed was appropriate for our goals and risk tolerance;
3) Rebalancing forces us to buy low and sell high, the stated goal of every investor!
Investors should probably not be swayed by a pitch stating the superiority of a bucketing approach over a traditionally diversified and rebalanced portfolio, as there is little evidence to support such a statement. Instead, we should view portfolios in their entirety and ensure that we have a well-defined investment policy and rebalancing system to maximize their odds of a successful period of financial independence.