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. The following is the first part of a continuing education course that will soon be available on Advisor.ca's CE Corner.
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 would be 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 would 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 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 or 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 (this page) 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.
Our primary focus is income, which is shown on the "income carpet" in Figure 2 (this page). The horizontal scale represents all starting years between 1900 and 2000. The vertical scale indicates the client's age.