I recently read an article that suggested more than half of advisors use some form of bucket strategy. But popularity isn’t always a sign of effectiveness. This course shows that bucket strategies are seriously flawed and should be avoided.
Retirement plan design criteria
When I entered financial planning from a career in engineering I was stunned by the prevalent practice: assume an average growth rate for the portfolio and then make a forecast for retirement assets.
That’s just like building the Eiffel Tower to withstand the average wind speed in Paris (let’s say it’s 6 mph). When the wind kicks up to 100 mph, the tower will likely collapse.
In engineering, we design for the worst-case scenario—and then some. The same applies when I design a retirement plan. While I agree past events will not be repeated in the future, knowing that a plan can cover the worst cases of the past elevates my confidence that it can withstand future black swan events.
We only use pure market history, starting in 1900 and ending at the close of 2012. We call this aftcasting, as opposed to forecasting. We do not use Monte Carlo simulators.
Aftcasting displays the outcome of all historical asset values of all portfolios since 1900 on the same chart, as if a scenario starts in each one of the years between 1900 and 2000. It gives a bird’s eye view of all outcomes, and provides success and failure statistics with exact historical accuracy because it includes actual historical equity performance, inflation and interest rates, as well as historical sequencing of all these data sets.
Standard Single Bucket
Scenario 1: Single bucket with fixed asset allocation
This is our base scenario. Bob and Jane, both 65, are retiring. They have a $1 million portfolio with an asset mix of 50% equities and 50% fixed income/cash. As the equity proxy, we use the Dow Jones Industrial Average (DJIA) total return (index plus dividends), less 2% for portfolio expenses, fees and other costs. On the fixed-income side, we use the historical 6-month CD rate plus 0.5% yield premium, net after expenses. This approximates a bond ladder with about a five- to six-year average maturity, held to the end date (no capital gains/losses).
Bob and Jane plan on withdrawing $45,000 annually, indexed to CPI. So their initial withdrawal rate is 4.5%. Their primary concern is the sustainability of their income stream—they want it to last until age 98. The probability of one of them living beyond that age is about 7%, which covers longevity risk.
Figure 1 shows the aftcast of asset values, represented by thin, grey lines. There is one line starting at the left vertical axis for each year since 1900. We define the bottom decile of all outcomes as the “unlucky” outcome, represented by the red line. The top decile is the “lucky” outcome, represented by the green line. The blue line is the median outcome, where half the scenarios are better and half worse.
Figure 1: Aftcast of Bob and Jane’s assets, Scenario 1
Our primary focus is income, which is shown on the “income carpet” in Figure 2. The horizontal scale represents all starting years between 1900 and 2000. The vertical scale indicates age. Each “knot” of the income carpet shows the level of income received at a given age and starting year, as a percentage of total income required in real, inflation-adjusted dollars. Different colors indicate different ranges of percentages as indicated in the legend to the right of the chart. In a nutshell, green is good, red is bad.
Figure 2: Income carpet for Bob and Jane, Scenario 1
The aftcast shows there’s a 23% chance Bob and Jane run out of income by age 97. This doesn’t meet our design criteria.
“What?! How can this happen?” you might say. “We have a 4.5% initial withdrawal rate, and the plan is still inadequate?”
The answer is yes, and the reason is simple. The major studies on sustainable withdrawal rates are based on calculated historical returns, but they miss the cost factor. Portfolio management costs, advisor fees, trading costs and all other expenses to hold and manage the portfolio increase the probability of failure. For this reason, we believe the famous “4% rule” is too optimistic. In our aftcast, we account for these costs to generate more realistic results.
There’s another factor affecting the outcome: we use a 32-year retirement time horizon, while the “4% rule” uses a 30-year timeframe.
Scenario 2: Single bucket with age-based asset allocation
This is a variation of the buy-and-hold strategy we saw in Scenario 1. Some think they can reduce the risk of running out of money during retirement by holding more fixed income as they get older. For example, instead of holding 50% equity in the portfolio for the rest of their lives, Bob and Jane hold a percentage of equity that is equal to 100 minus their age. So, they hold 35% equity at age 65, 20% equity at age 80, and so on.
In this case the probability of depletion at age 97 is 32%—worse than our base scenario.
Figure 3: Income carpet for Bob and Jane, Scenario 2
Scenario 3: Single bucket with a 5-year asset dedication
This is the same as the Scenario 1, except we have a new rule about asset allocation. Bob and Jane’s asset mix is still 50% equities and 50% fixed income/cash. However, we never allow the fixed income/cash portion of the portfolio to hold less than 5 years of income required from the portfolio.
The aftcast says the probability of depletion at age 97 is 27%—worse than our base scenario.
Figure 4: Income carpet for Bob and Jane, Scenario 3